By Arthur S. Rothschild

I got a call from a client who has a balanced portfolio – half stocks and half bonds, and he knows that interest rates are going to go up at some point. His question was what should he be doing differently?

It’s a question I’m hearing a lot lately. The answer requires an understanding of the purpose of each part of your portfolio as well as reasonable expectations.

Generally, I have encouraged clients to build balanced portfolios with stock funds for capital growth and bond funds for income and stability.

Our Federal Reserve has driven interest rates to all-time lows in an effort to stimulate a moribund economy. So now rates have only one way to go, and when interest rates move higher, bonds decline in value.

I talked with my client about duration. We can’t talk about it enough.

Basically, duration tells you how much the value of your bonds is going to fluctuate with interest rate movements.

If your duration is 3 years, that means for every 1 percentage point increase in the yield for the 10-year Treasury note, you’re going to lose 3%.

Say your duration is 3 years, and the yield on the 10-year Treasury goes up from 2% now to 5% five years from now. That means you’re going to lose 9%, but if it takes five years to do that, and you’re making 4% a year interest in a well-managed bond fund, then you’ll have made 20% in those five years and lost 9%. You’ve still netted 11% while those bonds have provided stability during all the bumps in the road.

For my client’s portfolio, bond funds are still providing the role that they played before. And that’s stability. That helped him make enough money without too much risk.

I pointed out to him that in the last couple of years, he has made more money from his bond funds because interest rates have gone lower than they should have. So he may have to give back some of that as rates go back up. That’s just what bonds do. They move up and down like pistons – or shock absorbers. Now it’s time for stocks to really start playing their role.

Even with the Dow Jones Industrial Average recently reaching an all-time high, stock valuations are relatively low by historical measures. And stocks stand to gain even more with ongoing growth in capitalism across the globe.

That’s what I talked about with my client. We decided that he should still stay in bonds, but we did sell one of his funds to get into a little more equity.

I didn’t really straighten him out. I just enlightened him a little bit. I looked at his portfolio and gave him a better understanding of what he has.

He had a good portfolio before. The only thing that really changed was that now he’s making more money on the stock side while the bond side is doing what it was supposed to do. So he didn’t need to make dramatic changes.

In the long run, we know that bonds aren’t going to do as well as stocks. But you can’t go out there with an offense and no defense. Just like a football team, you always have to have your defense on the sideline waiting for its opportunity. Bonds are your defense.

Arthur S. Rothschild, J.D., CPA, CFP, is a vice president at Landaas & Company. Contributing: Joel Dresang.

(initially posted March 19, 2013)

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