29 Mar Should I own bonds even though interest rates are low?
Q. A percentage of bonds has always been recommended for portfolios depending on age and risk tolerance.But bonds are not performing in this financial environment. Most bond funds I review are not providing a positive return. How can investors preserve capital?
A. It’s a great question.
Advisors often say you should include bonds in your investment portfolios for several reasons including income generation, capital preservation, capital appreciation and as a hedge against economic slowdown.
Interest rates offered by bonds have been falling for several years now, said Deva Panambur, a fee-only planner with Sarsi, LLC in West New York and an adjunct professor of personal finance at Montclair State University.
He said they dropped to record low levels in March 2020 when the Federal Reserve — the entity that manages the level of interest rates in the U.S. economy — slashed them in response to the turbulence caused by the coronavirus pandemic, he said.
“While they have climbed up recently, interest rates are still considerably low and so the expected return from bonds through capital appreciation and income is quite low,” he said. “For example, the 10-year U.S. Treasury, one of the safest bonds, currently has an interest rate of only 1.73% per year.”
However, he said, despite the low return potential of bonds, they still have a role to play in your portfolio for capital preservation and as a hedge against economic slowdown.
The best way to invest and compound your wealth in a reliable manner over the long term is to construct a well-diversified portfolio, Panambur said.
“Diversification has been called the only ‘free lunch’ in the investing word because it helps you reduce risk in your portfolio without necessarily reducing the expected return,” he said.
One of the ways to diversify is to include bonds in your portfolios, he said. That’s because in general, bond prices tend to move in an opposite direction to stock prices and that ‘negative correlation’ tends to act as a stabilizer in the portfolio when stock prices fall, especially during an economic slowdown, he said.
“The risk of investing in bonds when interest rates are low, is that you could suffer a loss when interest rates increase,” he said. “This is because bond prices fall when interest rates rise.”
There are ways to manage this risk such as by investing in short-term bonds, ones with a smaller number of years to maturity because they tend to be less sensitive to an increase in interest rates, he said.
“Ideally, portfolios should include a variety of bonds based on their maturity, credit quality, structure, type, etc.” he said.
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This story was originally published March 29, 2021.
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