The current low-yield environment has made it very easy for investors to question the value of holding bonds in their portfolios.  With interest rates staying low as long as they have, concerns have surfaced around frustratingly low yields, and the fear of rising interest rates decimating the value of bonds.  If bond yields can be matched by GICs, and GICs won’t lose value if interest rates rise, why would anyone hold bonds at all?  Let’s consider this question while ignoring the interest rate environment altogether. 

Bonds reduce volatility in a portfolio and provide an asset class that does not move in lock step with equities; they are not added to a portfolio to produce higher expected returns, but to allow investors to weather the inevitable swings in the equity markets.  When an investor looks at their fixed income allocation as a source of yield rather than a source of risk reduction, they are looking for yield in the wrong place.

In a strong economy with low yields, some investors begin to feel that they can simply replace their bond allocation with dividend paying stocks.  This strategy eliminates the risk reducing effects of a fixed income allocation and leaves the investor fully exposed to fluctuations in the equity market.  When investors begin searching for yield in their fixed income portfolio, they end up taking on additional risk rather than managing it.  Looking at bonds strictly as a risk management asset class changes the nature of the yield discussion.

Nobody can predict the future.  It is obvious that interest rates are low today, but nobody knows what they will be tomorrow.  When you are building a portfolio, it is important to focus on taking risks that have proven to have higher expected returns on the equity side while keeping a bond allocation in place to manage overall portfolio volatility.  By getting your mindset away from chasing yield in bonds, it becomes possible to construct a bond allocation using investment and higher grade short-term bonds.  These securities will have lower yields than low-grade or long term bonds, but they also carry less volatility.  Implementing this fixed income strategy allows investors to reduce interest rate risk in their bond allocation while also maintaining the liquidity that is necessary to systematically rebalance - something that is lost with GICs.

Every investor should appreciate the effects of exposure to riskier asset classes with higher expected returns, but it is important to understand that regardless of their yield there is no replacement for bonds in a robust portfolio.  So what do you do if interest rates rise and the value of your bond allocation goes down?  Rebalance by buying more high quality short-term bonds at the new, higher rates.

Original post at pwlcapital.com