What are the advantages of holding bonds?

We have seen in this post what bonds are. However have you asked yourself what are the advantages of holding bonds. We are going to have a look at the different uses of bonds for the average investor.

1. Safety investment

One of the most important uses of bonds for the average investor especially in this recession is to secure your portfolio. Investors who anticipates a bear market, turmoil in the stock market or a recession  might not want or have the courage to watch their portfolio’s value fluctuate widely. As a result in anticipation they will want to sell their investment and flee to the safest investment. Some will invest in treasury bonds, treasury bills, high quality corporate bond or money market mutual funds. After the events the investors can sell these safe assets and then reconstitute their portfolio. 

2. To maintain the value of the portfolio

The first use of bonds for the average investor is to maintain the value of the portfolio. Most bonds can be said to be quite safe especially if you invest in government bonds and investment grade corporate bonds. Because bonds are issued at a discount and then redeemed at face value the investor is certain that he will obtain more than he invested initially. Furthermore some bonds will pay coupons twice a year. So even if the return on bonds are small, the investor is assured to end up with more that he started with. If you invest in treasury inflation protected securities then your principal will be adjusted so that you will not be hurt by inflation. thus your return will always be greater than inflation.

3. Diversification

Diversification a strategy whereby you invest in a range of securities and in various sectors so that they will not be affected equally. If your portfolio is equally diversified it is possible that some of them will increase in value while while some of them will decrease in value thereby offsetting each other. Bonds are the best asset to hedge against stocks. As you the value of stocks increases and decreases while that of bonds will remain the same. Hence when the stock market is down the presence of bonds will reduces the loss of value of the portfolio. Now when the stock market is up the percentage of stocks in the portfolio increases as a result to keep the value of bonds in the portfolio constant you will have to rebalance. You will thus sell stocks to buy bonds. This will ensure that you lock the gain in stock market by buying bonds.

4. Fixed income generation

Some people, especially retirees need a regular source of income. Because bonds pay regular coupon every six months a portfolio that has a sufficient number of bonds in it will provide income to the retiree on a regular basis. Stocks on the other hand pay dividends but it is not compulsory for companies to pay dividends so an investors that have stocks in his portfolio is not certain of receiving dividends on a regular basis. However since on the long run the stock market rises then the investor is sure that the value of his stocks will increase with time.

As you can see it is very important to have a certain percentage of you money invested in bonds for the presence of bonds will help to stabilise your portfolio. 20 % for the aggressive investor up to 40 % for the prudent investor is an appropriate allocation. However make sure that your bonds are sufficiently diversified ranging from safe government bonds to slightly yieldy corporate bonds. If you are adventurous you can invest in municipal bonds.

Strategies of the successful investor part 4: Rebalancing

One of the most important aspect of your investing life is rebalancing. As you know a portfolio must be diversified in that the portfolio is composed of a wide variety of asset types such as bonds, stocks, etc. Depending on your investment plan and your risk tolerance the different asset classes will be a certain percentage of the portfolio. And in each asset class their would also be some diversification.

You would probably have stocks that are in different sectors of the economy or bonds that are from different types of issuers such as corporate bonds, municipal bonds or government bonds.

Hence it is important that your portfolio composition be as close as possible to that that your plan states. However the economy is not static. Depending on the state of the economy some stocks might increase in value while others decrease in value. This will cause your exposure to these sectors to change. The percentage of the stocks of some sectors of the economy will increase or decrease in your portfolio.

The change in price might also change your exposure to some asset classes. A bull market might increase the percentage of stocks in your portfolio while reducing the percentage of bonds in your portfolio. If left unchecked the asset allocation of your portfolio will change with time and also the riskiness of your portfolio will change. This might thus reduce your chance of reaching your goals.

Thus you need to rebalance regularly. At least once a year is sufficient. Your aim is to reduce your exposure to certain asset classes that have increased in value while increasing your exposure to those that has decreased in value. You will thus return your asset allocation to that that is stated in your investment plan.

You will thus have to sell securities and buy others. This is the most difficult part for some investors because of the cost involved in selling and buying securities. Also some investors may not like selling performing stocks and buying poor performing stocks. However history tells us that a portfolio left to fluctuate with the market always perform poorly.

So keep rebalancing and your portfolio and you will be on course to riches.