By Art Rothschild

A day doesn’t go by that a client doesn’t raise the question, “Why do I even have bonds if you guys expect stocks to keep going higher?”

One client, a business executive who has an MBA, asks, “Art, why do you want to put any of my money in bonds when we know that the Federal Reserve is going to raise interest rates, and we know that when interest rates go up, the values of bonds go down?”

Our answer is the same all the time:

1. Unlike stocks, which can rise and fall dramatically on a daily basis, bonds are more stable. Holding bonds in balanced portfolios smoothes out performance and reduces the risk of owning stocks.
2. Bonds pay interest on a regular basis. They represent a promise to pay by the issuer and should provide a steady stream of income typically higher than the yield available on stocks and again – depending on the credit quality of the issuer – with less risk.
3. Different types of bonds react differently in different economic environments. We are always making sure that our clients have a variety of bonds. Just as we have small-cap stocks, large-cap stocks, growth stocks and value stocks, it’s appropriate for every investor to have some amount of higher-quality bonds, lower-quality bonds, longer-maturity bonds and shorter-maturity bonds.

We know the Fed is going to raise interest rates at some point. We don’t know when that is going to happen or how much they’re going to raise rates or how quickly.

But we do know that when they raise rates, even though they’re raising short-term rates, longer-maturity bonds have potential to lose more. Generally, the longer a bond is locked into a lower rate, the more its value falls as other rates go up.

Our advice isn’t to avoid bonds. It’s to use them judiciously.

That’s why we check the duration in every portfolio we manage and make sure durations are appropriately short. Furthermore, we have an extra layer of insulation because we select well-managed bond funds whose managers can adjust their portfolios in anticipation of changing interest rates and in order to capitalize on opportunities available by owning different types of bonds through all market cycles.

Plus, we have confidence that the Fed is going to let us know enough in advance – as they did in 2004 – that they’re intending to raise rates. That way, every bond manager can shorten maturities of the types of bonds most sensitive to the higher interest rates.

There has been talk of rising interest rates for over a year. The yield on the 10-year Treasury bond is actually lower now than it was a year ago, although it is a full percentage point higher than it was six months ago. Despite that, many investors in well-managed bond funds have actually made money over the last six months.

Art Rothschild is a vice president at Landaas & Company.

(Joel Dresang, vice president of communications at Landaas & Company, contributed to this article.)

(Part of this article was adapted from Art’s monthly column in the Racine Journal Times. For an archive, please click here.)

initially posted April 11, 2011

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