This is the last installment in the series.
There are two risks associated with bonds: default and price volatility. There are two metrics for evaluating bonds: quality and maturity.
The price of a bond (what we could sell it for) is partially determined by how its interest rate, or yield, compares to newly available bonds. If yields are dropping, the price of a bond I already hold will go up. If yields are rising, the price will drop. Default is simple: when a corporation declares bankruptcy, debts are paid from senior to junior. Publicly traded corporate bonds are classified as junior debt.
The two metrics are best understood when we analogize bond investing as renting. If dollars are the property that is being rented, and if interest is the rent being paid for the use of those dollars, it follows that:
The riskier a borrower, the higher their cost of capital (interest rate). And that the longer the borrowing timeline, the higher the interest rate. Lower quality and longer maturity will both result in higher interest rates. Long maturity also increases the risk of price drop.
What is the purpose of debt securities (fixed income) in an investment portfolio? The most well-informed answer is: stability. Rebalancing is a crucial task in any long-term investment approach. When stock markets crash, usually they all crash together. We need something to rebalance against that will not be crashing at the same time. What fixed income is not for is to produce returns. That is what our stock exposure is for.
We use only short-term, high-quality debt securities in all fixed income portions of client’s portfolios. This is the most straightforward method for achieving stability sufficient to rebalance against. These rules do not change over time.
Ugly truth: (you’ve seen this before) you cannot achieve stock market returns in the bond market or in Real Estate with lower volatility.
Beautiful truth: you do not need to trade stocks in order to invest prudently. You need coaching.
Simon Joshua is a licensed investment advisor representative at Cornerstone Wealth Partners in Michigan. He has structured his practice around investor coaching and committed himself to leading communities in establishing a legacy of fulfillment.