How to Manage Risk With Bonds in Your Portfolio
Traditionally portfolio managers and investment advisers have used bonds to help manage the inevitable volatility of equities. And, in the past, this strategy has served investors well. The relatively stable income produced from a diversified bond portfolio along with the historically low fluctuation in bond pricing leads people to think that this may be the best method to hedge the risk associated with their investments in stocks, mutual funds and ETFs. Also, since the cycle of market risk is not necessarily coordinated to the risks associated with bonds, many investors are holding bonds or bond funds as a risk management strategy.
Bonds Are Not Immune to All Risks
But the income produced by bonds and the lower volatility of bond prices do not make them immune to risk of principal. Unfortunately, many forget that there are multiple risks associated with bonds other than the market risk that most people are used to with stocks. The types of risk bond investors face include (but are not limited to): interest rate risk, default risk, inflation risk, reinvestment risk, liquidity risk, ratings risk and underwriting risk. The most obvious (and urgent) risk facing bond investors is interest rate risk. As interest rates rise, the market price of existing bonds will fall (inverse relation of bond prices and interest rates). Those that own short-maturity, direct bond holdings will be able to hold their bonds until maturity and get their par value (assuming the bond does not default or is called). However, most bond investors own bond funds (in which they cannot control the selling of their bonds) or own direct bond holdings with long maturities (which they would not want to hold until maturity if they could get better interest rates in the current bond market). In that sense, interest rate risk in bonds is a very real risk for most investors. (For related reading, see: Managing Interest Rate Risk.)
Stock Prices and Bond Pricing Are Currently High
There is also a notion that bonds are currently more correlated to stock prices now than ever. We are currently at a historically high level in stock pricing and bond pricing at the same time. This is somewhat unprecedented in our investment markets and poses a great problem for many investors. People with traditional (model) portfolios that have a certain percentage of their assets in stocks and certain percentage of their assets in bonds may want to ask themselves one simple question: What happens if the stock market drops and interest rates rise (bond prices fall) at the same time? For those investors, they will want to consider alternative asset allocation strategies not correlated to bonds or stocks.
If bonds are being used as a risk management strategy, it may be best to consider lower duration, direct bond holdings, not bond funds or direct bond holding with long maturities. And it may be best to consider some bond alternatives in the portfolio that can offer principal protection without any type of risk, interest rate risk or otherwise.