Bond investing in bad times
A bond is defined as an interest-bearing certificate issued by a government or business, promising to pay the holder a specified sum on a specified date.
Common wisdom says bonds are a safe haven from stock market turmoil. Does that mean you should buy bonds if that turmoil comes from recession or inflation?
Complicating the situation is the fact that there is no one-size-fits-all-situations bond. The Treasury Department issues bonds, so do corporations, municipalities and banks. There are short-term bonds and long-term bonds; bonds with pristine credit ratings and junk bonds.
Remember, while bonds may protect you in hard economic times from the deep dives that stocks sometimes take, there is no guarantee you won't lose money. With bonds, you can get hurt while standing on the sidelines.
Stability versus volatility
It's a given that most people, especially as they near retirement and need to reduce volatility in their portfolio, should have a smattering of bonds for stability and to provide fixed-income.
The ratio of bonds to equities and cash depends on your needs and your risk tolerance. We won't specifically address allocation in this article,
but we will try to provide some guidance for when it's appropriate to load up a bit more on your bond allocation.
Cash, U.S. bonds and foreign bonds
David Marotta, president of Marotta Asset Management in Charlottesville, Va., includes three asset classes in the stability portion of his clients' portfolios.
The first is "short money," comprised mainly of money markets and, occasionally, short-term CDs; assets that mature in less than two years. Second is U.S. bonds, and the third is foreign bonds.
"Short money has probably been
the riskiest investment over the past couple
of years," says Marotta. "The dollar has dropped
in value and its buying power has dropped
tremendously. By proxy, the second riskiest
investment is U.S. bonds. They've appreciated
some in the recent market downturn, they've
paid a little bit better interest rate, but
in terms of purchasing power, they've been
one of the worst investments in the last two
||Bond -- An interest-bearing certificate issued by a government or business, promising to pay the holder a specified sum on a specified date.
||Risk tolerance -- An investor's ability to psychologically endure the possibility of losing money.
|See the Guide's Glossary for a further explanation of these terms.
"Foreign bonds do the best
during a recession and during inflation. During
a recession, the bond category as a whole
will do well, but during inflationary times,
the U.S. dollar is dropping in value. Your
foreign bonds are going to get both the good
return you get in a bond portfolio during
a recession and an extra kick because the
value of the U.S. dollar is dropping.
"When the dollar drops, your
foreign bonds are going up in value because
they're invested in foreign currencies, which
aren't being devalued as much as the dollar.
When you invest in foreign bonds in this mode,
you want to invest in unhedged foreign bonds."
Hedged versus unhedged
Since individual bonds can be too pricey for many individual investors, consider bond funds. An unhedged foreign bond fund is one that is denominated in foreign currencies. Sometimes the word hedged or unhedged will be in the funds title, such as PIMCO Foreign Bond (Unhedged). If it's not noted in the fund name, check the fund's description or profile.
You're deliberately exposing yourself to currency fluctuations when you buy an unhedged bond or bond fund. A foreign bond fund that is U.S. dollar hedged will limit its exposure to foreign currencies. In other words, you're limiting your exposure to currency fluctuations.