For most of the last century investment advisers have encouraged investors to diversify their portfolios between stocks and bonds.
The thinking behind this split stems from past history.
When the stock market goes up bonds usually come down and the reverse happens when the stock market goes down.
This portfolio diversification uses bonds as a form of insurance against severe stock declines. Most of the time when stocks move one way bonds move the other direction.
That practice caused a lot of financial grief in the first half of 2022 when bonds and stocks both fell in value as inflation saw bonds sell off and slow growth pushed stock values down. That only happens once in a while.
The suggested split for diversity has been 60 per cent stocks and 40 per cent bonds.
Bonds also provide investors with a steady stream of regular interest income.
With the principal of investments in some bonds guaranteed by governments since the Second World War many investors fail to realize how most bond values change before the bond expires and investors are repaid in full.
Most bond issues are sold outside of those bonds guaranteed by government. Value of these bonds fluctuates with the market.
Example: A new bond sells for $1,000 with five per cent annual interest of $50 paid.
Five per cent is the current interest rate but within weeks the current interest rate rises to 5.5 per cent.
The $5 annual interest payment, for the market, becomes six per cent and the $1,000 bond loses one-tenth its value to $900, if sold.
The opposite happens when interest rates fall. If the current five per cent interest rate fell to four per cent, in this example the bond value would jump by 20 per cent to $1,200.
Bonds are not the most stable part of an investment portfolio unless held to the date of maturity when the principal is supposed to be paid in full.
Maturity dates on bonds vary from three to 20 years. Investors fearing large interest changes may want to buy shorter maturities.
As interest rates declined in the last 15 years more investment counsellors suggested the stock/bond split be 70/30 per cent. Recent interest rate hikes have ended that notion.
Bonds may be less risky than stocks but they carry the risk of major price changes from interest rate moves.
Bonds come in secured and unsecured form.
Secured bonds have first claim on all the assets if the company goes under or fails to pay at maturity date.
Unsecured bonds have no such claim on assets and are riskier, usually paying higher rates of interest.
If bondholders do have to make a claim on assets of the bond issuer, they rarely get 100 per cent of their money back. The process can take years.
Ron Walter can be reached at ronjoy@sasktel.net
The views and opinions expressed in this article are those of the author, and do not necessarily reflect the position of this publication.
