The first thing I learned about bonds is that when interest rates rise, the price of existing bonds tends to fall. Unfortunately, I didn't learn much else about bonds. So I have a couple questions about them.

  1. If interest rates rise I'm sure it will affect some kinds of bonds more than others. What are the different kinds of bonds and how do they fare in time of changing interest rates?
  2. My financial planner suggested 20% of my 401(k) should be in bonds. (I am decades away from retirement.) What do they add to my portfolio in terms of risk and diversification? (I guess I'm asking why wouldn't I drop most of the bonds from my portfolio since they've been outperformed by my mutual funds over the last couple years when interest rates have been stable?)
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1. Interest rates

What you should know is that the longer the "term" of a bond fund, the more it will be affected by interest rates. So a short-term bond fund will not be subject to large gains or losses due to rate changes, an intermediate-term bond fund will be subject to moderate gains or losses, and a long-term bond fund will be subject to the largest gains or losses.

When a book or financial planner says to buy "bonds" with no other qualification, they almost always mean investment-grade intermediate-term bond funds (or for individual bonds, the equivalent would be a bond ladder averaging an intermediate term).

If you want technical details, look at the "average duration" or "average maturity" of the bond fund; as a rough guide, if the duration is 10, then a 1% change in interest rates would be a 10% gain or loss on the fund. Another thing you can do is look at long-term (10 years or ideally longer) performance history on some short, intermediate, and long term bond index funds, and you can see how the long term funds bounced around more.

Non-investment-grade bonds (aka junk bonds or high yield bonds) are more affected by factors other than interest rates, including some of the same factors (economic booms or recessions) that affect stocks. As a result, they aren't as good for diversifying a portfolio that otherwise consists of stocks. (Having stocks, investment grade bonds, and also a little bit in high-yield bonds can add diversification, though. Just don't replace your bond allocation with high-yield bonds.)

A variety of "complicated" bonds exist (convertible bonds are an example) and these are tough to analyze.

There are also "floating rate" bonds (bank loan funds), these have minimal interest rate sensitivity because the rate goes up to offset rate rises. These funds still have credit risks, in the credit crisis some of them lost a lot of money.

2. Diversification

The purpose of diversification is risk control. Your non-bond funds will outperform in many years, but in other years (say the -37% S&P 500 drop in 2008) they may not. You will not know in advance which year you'll get.

You get risk control in at least a few ways.

  1. Rebalancing. When the S&P 500 dropped 37%, you would move a bunch of bonds into stocks. Then when the S&P 500 went back up, you bought more stocks at a low bargain price, and now you have a lot more stocks. Over time this gives you higher and more predictable returns.
  2. Timing. If you for some reason need to withdraw money at time T, then less unpredictable bouncing around in your portfolio makes it more likely that you aren't selling at some horrible low point. A diverse portfolio, in the aggregate, does less bouncing. Also, you would have the option of cashing out the bonds instead of the stocks, if stocks were too low. Then you could wait for stocks to go back up some and sell the stocks later to re-establish your bond percentage.
  3. Behavior. If you have 100% stocks and the market drops 37%, empirically speaking, many if not most people will freak out and sell the stocks low, which has dire consequences offsetting any extra return you could possibly hope to get from 100% stocks. Of those who don't freak out and sell, most will at least freak out and experience substantial mental anguish and distraction.

There's also an academic Modern Portfolio Theory explanation for why you should diversify among risky assets (aka stocks), something like: for a given desired risk/return ratio, it's better to leverage up a diverse portfolio than to use a non-diverse portfolio, because risk that can be eliminated through diversification is not compensated by increased returns. The theory also goes that you should choose your diversification between risk assets and the risk-free asset according to your risk tolerance (i.e. select the highest return with tolerable risk). See http://en.wikipedia.org/wiki/Modern_portfolio_theory for excruciating detail.

The translation of the MPT stuff to practical steps is typically, put as much in stock index funds as you can tolerate over your time horizon, and put the rest in (intermediate-term investment-grade) bond index funds. That's probably what your planner is asking you to do.

My personal view, which is not the standard view, is that you should take as much risk as you need to take, not as much as you think you can tolerate: http://blog.ometer.com/2010/11/10/take-risks-in-life-for-savings-choose-a-balanced-fund/ But almost everyone else will say to do the 80/20 if you have decades to retirement and feel you can tolerate the risk, so my view that 60/40 is the max desirable allocation to stocks is not mainstream. Your planner's 80/20 advice is the standard advice.

Before doing 100% stocks I'd give you at least a couple cautions:

  • I believe 90% stocks 10% bonds does better on average historically than 100% stocks, because of the value of diversification.
  • stocks outperform bonds reliably only over 20-30 year time horizons, if you never panic or screw up or take the money out of the stocks in that entire length of time. 10 years is not long enough. Just look at 2000-2010.

See also:

  • 3
    +1 Great answer. I'd add that, according to the books with pretty graphs based on MPT, a 90/10 split has a significantly lower expected risk with a nearly identical expected return of a 100% stock -- the risk reduction is "free". – bstpierre Apr 16 '11 at 16:27
  • Note that even if the hypothetical 10-year bond fund sees rates rise 1% and loses ~10%, you still get all your money back.... if you wait the whole 10 years. (Of course, by that time, the fund will have purchased newer bonds as well; this is one difference between a bond fund and a direct investment in bonds.) – fennec Apr 19 '11 at 14:36
  • @fennec, so a bond fund is less affected by rates changes, right? – datasn.io Mar 13 '14 at 12:15
  • @kavoir.com - less affected by rate changes than which? an individual bond? A bond fund is exactly as-affected by rate changes as the bonds it is comprised of. On any given day, if you have an individual bond with the same maturity as the average bond in a chosen bond fund, the sensitivity to a rate change should be approximately the same. (Not quite exactly the same; there are some non-linearities involved in the way interest rate sensitivity accumulates. I'm not qualified to explain it, and there's calculus involved. But rather close.) – fennec Mar 16 '14 at 20:55

When interest rates rise, the price of bonds fall because bonds have a fixed coupon rate, and since the interest rate has risen, the bond's rate is now lower than what you can get on the market, so it's price falls because it's now less valuable.

Bonds diversify your portfolio as they are considered safer than stocks and less volatile. However, they also provide less potential for gains. Although diversification is a good idea, for the individual investor it is far too complicated and incurs too much transaction costs, not to mention that rebalancing would have to be done on a regular basis. In your case where you have mutual funds already, it is probably a good idea to keep investing in mutual funds with a theme which you understand the industry's role in the economy today rather than investing in some special bonds which you cannot relate to. The benefit of having a mutual fund is to have a professional manage your money, and that includes diversification as well so that you don't have to do that.

  • I guess I should have mentioned, the bonds in my portfolio are in the form of an indexed bond fund designed to give "broad market" coverage. I guess that means it invests in all kinds of bonds. – Stainsor Apr 16 '11 at 2:04
  • @Stainsor: See Havoc's answer about "duration". Read the prospectus for your fund and it will have the average duration as well as information about the issuers of the bonds it does invest in (govt, agency, mortgage backed, foreign, high quality corporate, etc) and whether there are constraints on the target average maturity. – bstpierre Apr 16 '11 at 16:29

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