The Role of Bonds In Your Portfolio 2022
Ann D. Blakey, CFP® at Washington Wealth Advisors
Many individuals generally view bonds as conservative investments that offer a higher degree of protection of principal than stocks. However, 2022 has shown that bond prices can also be volatile, since both stock and bonds indexes have lost value so far this year. Therefore, it’s important to review the role that bonds play in your portfolio. While bond prices have declined, the consistent income features of bonds can be especially important during economic downturns.
Equity vs. Fixed Income
When it comes to investing, you can be either an owner or a lender. If you own stock (or shares of a mutual fund that invests in stocks), you are a shareholder and literally own a part of a company. You have “equity” in the company. However, the company has no obligation to pay you back and the value of your shares will rise or fall with the fluctuations of the market. Dividends are paid on some stocks, but they are not guaranteed.
On the other hand, when you buy bonds (or bond funds), you are acting as a lender. That is, you are lending your money to an entity (e.g., a company, state, municipality, or the U.S. government) for its promise to pay you, which takes the form of periodic interest (“fixed income”) and a return of your principal. Unlike a stock, the borrower does have an obligation to you (the bondholder), to repay.
With a stock, your primary profit will come from selling your shares at a higher price than you bought them. There are two ways that you can profit from a bond – from the fixed interest a bond pays and from any increase in the bond’s price.
Bond Basics - Yield vs. Interest
One of the most common questions posed by potential bond investors is: “What is bond yield?” Bond yield is most simply defined as the overall rate of return on your investment. This is not the same as a bond’s interest.
As discussed, typically bond interest is fixed. However, just as a bond’s price can fluctuate, so can bond yields. This is because the yield is a function of both the bond interest and the bond price. Yields move inversely to prices. Therefore, when bond prices decline, as we have seen in 2022, bond yields increase.
There are several factors that can affect yield. One of the more important considerations is credit rating. Other factors that are particularly relevant to 2022 are inflation and interest rates. A rise in either of those tends to cause bond prices to drop, which causes bond yields to increase.
Before You Decide. . .
Bonds can be a valuable addition to your portfolio because of their dual potential for profit. However, the percentage of your portfolio you choose to invest in bonds should be determined by your overall goals and objectives. Moreover, inflation and interest rates do not impact all bonds in the same manner.
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