Bonds will be a terrible investment over the next 10 years. That is the conventional wisdom in the investment community lately.
“Bonds are the worst asset class for investors,” says Professor Burton Malkiel, the author of A Random Walk Down Wall Street, in an opinion piece published in late March in The Wall Street Journal. “Usually thought of as the safest of investments, they are anything but safe today. At a yield of 2.25%, the 10-year U.S. Treasury note is a sure loser.”
This prediction may or may not be correct; however it is important to review the reasons why investors should hold bonds in a diversified portfolio.
What Are The Risks of Owning Bonds?
There are 3 components of risk in owning bonds. Issuers of bonds (corporate or government) can default and not repay you. Default risk can be very low (U.S. Treasuries) or quite high (corporate junk bonds). As interest rates rise, the market value of your bond holdings will go down (interest rate risk). Over the past ten years bond returns have been very good due in large part to the increase in market value as rates went lower and lower. Inflation is a source of risk that greatly impacts an investor’s purchasing power in retirement. For retired investors, interest and dividends are an important source of income. If inflation outpaces interest rates, the bond investor’s purchasing power decreases.
It is likely that bond returns will not be nearly as good as they have been over the past ten years. So what should an investor do about it?
I don’t recommend selling bonds and buying either cash or stocks. However, there is merit in adding longer-term Treasury Inflation-Protected Securities, or TIPS, and short-term corporate bonds into a portfolio for investors willing to accept the additional risk. There is no way to reliably predict future interest rates or inflation, so most investors will fare very well by leaving their bond allocation alone and riding out the market cycle.
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