Bonds provide a safety net for your portfolio when times are tough

With all the sizzle and excitement in the stock market, bonds don’t always get the respect they deserve from individual investors. After all, how can you get excited over returns of 5% or 6% in bonds when you can have profitable periods of 25%-plus in stocks?

It’s easy: when stocks hit their inevitable down periods, bonds can prop up a portfolio, smoothing out its long-term returns and making it easier for an investor to handle market volatility. That’s why bonds have long been one of the most fundamental diversifiers for investors. The old adage is that you buy stocks to make money and bonds so that you can sleep at night.

For instance, over the 30 years ended in August, the Standard & Poor’s 500 Stocks index returned an average of 12.3% per year. Investing 60% of a portfolio in that stock index and 40% in the Lehman Aggregate Bond index produced an average annual return of 11.2%. But the volatility of the stock and bond portfolio was only about two-thirds the risk of investing in stocks alone.

During the 2000-02 bear market investors got a vivid lesson of just how valuable bonds can be. Stocks plummeted for three years in a row while bonds offered above-average returns. For instance, during 2002, the worst year of the stock slump, the S&P 500 lost a little more than 22%. The Lehman Aggregate Bond index, however, gained over 10%. The worst calendar-year loss for the bond index since 1976 was a decline of just under 3% in 1994.

Bonds often do well during economic slowdowns because interest rates either hold steady or are cut by the Federal Reserve in order to stimulate the economy. These are just the periods that stocks tend to do their worst as investors fret about declining corporate profitability. Inflationary periods are anathema to bonds because their fixed interest rates may not keep up with rising prices. Stocks, however, can do well in these periods because companies have the ability to raise prices and sell more products or services, generally the formula for increasing profitability.

The lower volatility of portfolios that include bonds can help investors avoid two types of loss: market-driven losses due to extended declines in stock prices, and investor-driven losses caused by panic sales in bear markets. In other words, by controlling the size of inevitable short-term portfolio declines, an investor can avoid distress that would cause him to sell at the wrong time. When investors panic and sell they can lock in a short-term loss and miss out on the inevitable market recovery.

Some investors may be drawn to long-term bonds because they usually offer higher yields. However, they don’t help as much with the primary objective of using bonds in a portfolio because they can be almost as risky as stocks. Long-term bonds react with larger price swings when interest rates go up and down. Meanwhile, stock investors get more potential reward for accepting risk than do long-term bond owners. That means it is better to use short or intermediate term bonds to reduce portfolio risk.