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Why It Pays to Include Bonds in Your Portfolio

Bonds bring benefits to investors.

Stocks may represent the more glamorous side of investing, but investors can’t overlook the role of bonds in a diversified portfolio. Fixed-income securities are typically far less volatile than equities. For this reason, they should serve as ballast, to counteract the relatively normal volatility of stocks. But how should investors incorporate bonds into their existing portfolios? Not all bonds are the same, and you don’t want to choose something just because it’s performed well recently. While that may seem like an appealing and even intuitive way to choose investments, that is not the best way to allocate.

A matter of interest (rates).

It’s important to take a step back, and understand the current environment. Interest rates remain low by historical standards, but have had recent bouts of creeping higher. At the end of February, the interest rate on the 10-year Treasury note was 2.717 percent, down from its one-year high of 3.248 percent in October. Even though it’s unclear how soon rates will rise, and how high they will go, investors would be wise to understand how to respond when rates inevitably inch up.

The risk of long-term bonds.

For starters, avoid longer-term bonds, which are riskier than those with shorter maturities. Bonds with longer terms to maturity generally pay a higher interest rate. A longer-term bond has more exposure to inflationary pressures over time, along with bigger risk that rising interest rates could result in a price decline. Any intelligent person could, with a few minutes of online research, make a reasonable guess about where interest rates might be a year or two from now. Over the long haul, though, nobody could possibly know. Too many things in the economy could change between today and 2039 or 2049. This greater uncertainty is why holders of long-term bonds demand to be paid more.

What premium really means.

The term premium is what investors receive with the higher coupon rates for longer-term bonds. This is a driver of return for fixed income. However, don’t look to the bond side of your portfolio as the place to eke out the highest return; that’s what stocks are for. Bonds with maturities between one and seven years are generally the right investment for most people with a long time horizon. In fact, consider tilting toward bonds with maturities of no more than five years. These short- and intermediate-term bonds yield more than money market accounts, and are less volatile than their longer-term cousins.

Avoid the yield pitfall.

Seeking higher return on the bond side leads investors to another potential pitfall: chasing yield. That happens when an investor looks to higher-yield bonds without realizing that these instruments often represent debt of companies or municipalities that may be at risk of not repaying bondholders. The term “high yield,” as applied to bonds, sounds much better than “junk,” although they mean the same thing. Don’t be swayed by the higher coupon rate or the higher expected return of a junk bond fund. While a higher yield sounds attractive, it also comes with increased volatility. If you own stocks, you already hold an investment that is inherently more volatile.

Prepare for the future.

In the near term, as investors ponder the effects of gradually rising rates, consider paring down longer-term and lower-credit-quality bond holdings. If rates climb higher over the next few years, and you need to sell holdings at some point, you may be disappointed — or worse — when the bonds don’t fetch as much as you expected on the market. On the credit-quality side, check for bond funds with “high yield” in their names. These are almost certainly junk bond funds. Their performance tends to align with that of the stock market, and can drive down your overall return if stocks also turn lower.

Align with your financial goals.

As a general rule, be sure your investment portfolio is aligned with your goals, whether they are strictly long-term, like retirement, or if they include shorter-term items, such as college funding. Once you ascertain that your risk profile and expected return are appropriate for your goals, time horizon and overall circumstances, you can generally ignore short-term market noise and focus on the bigger picture.

Things to remember about bonds.

Investors are encouraged to include bonds in their portfolio. Here are some things to know:

— Bonds reduce volatility.

— Interest rates have real effects.

— Shorter-term bonds may be best.

— Resist the lure of “high-yield” bonds.

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Why It Pays to Include Bonds in Your Portfolio originally appeared on usnews.com