Expected returns for stocks are 8% to 10% annually. Expected returns for bonds are in the 4% to 5% range. So why do we hold bonds in our portfolios? Generally speaking, there are four main reasons to hold bonds.

1. Bonds lower the risk and dampen volatility in a portfolio.

  • Bonds are safer securities than stocks. Bondholders of a corporation get paid before stockholders. The variability of bond returns is less than half that of stocks. Bond returns are, more often than not, inversely correlated with stock returns. That is, when stock prices are down, bond prices are usually up (not always as we witnessed in 2022!) and vice versa.
  • Bonds reduce the total risk in a portfolio. The lower risk of bonds results in a lower expected return. Inclusion of bonds lowers the overall risk in a portfolio, at the cost of a lower expected total return.

2. Bonds provide a better source of liquidity than stocks.

  • When planning for cash needs from a portfolio, bonds (especially short-term bonds) provide a far more reliable source of liquidity than stocks, as bond prices are not nearly as variable as stock prices.
  • For those who need to plan for cash needs from their portfolio, holding bonds significantly increases the probability of not having to sell stocks at an inopportune time.

3. Bonds provide a predictable stream of current income.

  • Whereas the primary return from stocks comes from price appreciation over a long period of time, the return from bonds is primarily generated from interest payments.
  • Bonds pay interest at a stated rate, usually on a semi-annual basis. So, income from bonds is quite consistent, can be calculated, and is received at known intervals.

4. Bonds provide a strong rebalancing tool in a portfolio.

  • We manage portfolios to a target allocation between stocks and bonds and we rebalance to that target periodically.
  • As bond prices usually increase when stock prices fall, holding bonds when stock prices drop allows us to rebalance by selling appreciated bonds and buying “cheap” or depressed stocks. Over time, this type of rebalancing enhances portfolio returns.

Whether or not to hold bonds in your portfolio and how much of your portfolio should be in bonds is a question to be answered for each person or family. For a younger person who is not bothered by the risk of stocks, there is not much need to hold many bonds in their 401K. If someone of any age can’t tolerate the inevitable large declines in the stock market, they should hold some amount of bonds. If you are in or close to retirement and will be needing cash from your portfolio, holding bonds is a necessity. Additionally, the percentage of bonds in your portfolio will likely vary over time.

The decision comes down to an analysis of each person’s current and expected future circumstances, their expected needs from their portfolio, and their ability to tolerate stock market risk.