Fixed Income Basics: Three Reasons to Hold Bonds in a Portfolio
An investment portfolio is like a symphony. The right instruments making the right sounds in the right order can produce a beautiful piece of music with an effect greater than the sum of its parts. In a similar fashion, most successful portfolios are allocated between stocks, bonds, cash, and other asset classes to meet the goals, risk tolerances, and time horizons of investors.
Just as an orchestra would be incomplete without a section of strings, so too are most portfolios without an allocation to fixed income. But what functions are bonds playing in an investment portfolio? Below we explore three primary reasons why investors might choose to allocate a portion of their portfolio to fixed income instruments.
Diversification
It’s very difficult to determine which asset classes will perform the best (or worst) from year to year, so having a portfolio that is broadly allocated to a variety of asset classes is crucial to capture steady returns with lower risk and lower volatility. An allocation to fixed income securities improves risk-adjusted returns, and contributes greatly to healthy diversification in an investment portfolio. In other words, don’t put all of your eggs in one basket.
Protection
Investing in fixed income instruments is generally considered less volatile than investing in other asset classes or even than holding cash over the long-term. Cash held in a bank account will slowly lose purchasing power over time due to inflation, while stocks can experience greater turbulence. Fixed income assets can act as a counterweight to protect capital in years when stocks and other asset classes potentially incur losses.
Income
A very attractive feature of bonds is the ability to know ahead of time how much interest they will pay out in the future, allowing for steady, predictable income in a relatively low risk asset. Fixed rate coupon bonds explicitly state the rate of income, and floating rate products often have a coupon floor to ensure an investor knows the level of income in the least favorable scenario. The cash flow component of fixed income provides a cushion for the price volatility of an investment portfolio over the long-term.
The appropriate level of fixed income allocation for your portfolio should be determined by your goals, risk tolerance, and time horizon.
Talk to your Davenport Financial Advisor today for more information about the right fixed income allocations, strategies, and products for your portfolio.
The statements and opinions expressed in this article are those of the authors as of the date of the article, are subject to rapid change as economic and market conditions dictate, and do not necessarily represent the views of Davenport & Company LLC. This article does not constitute investment advice, is not predictive of future performance, and should not be construed as an offer to sell or a solicitation to buy any security or make an offer where otherwise unlawful. Investing in securities carries risk including the possible loss of principal. Individual circumstances vary.