I think investors often miss the point of bonds in a portfolio.  And not just individual investors – pension funds, financial advisors and portfolio managers are guilty as well.  In my opinion, the role of bonds in a diversified portfolio is to reduce the overall risk of the portfolio.  Plain and simple.  Because stocks have high risk/reward characteristics, bonds should help offset those risks with low risk/reward characteristics.

Volatility reducing bonds are US treasuries, some foreign sovereigns, agency mortgage backed securities, municipals and very high grade corporate bonds (among others).  These bonds historically have maintained their value when stocks are selling off – this reduces volatility in the portfolio and helps keep clients invested when panic is in the air.

The other types of bonds that I did not mention are where you run into trouble.  High yield bonds, emerging market bonds and floating rate bonds all fit into the “other” category.  These bonds tend to yield more than the “risk reducing” bonds but there is a reason – the prospect of default (credit risk) is much higher.  These bonds have high risk to reward characteristics – they can have double digit returns in “up years”, but also double digit losses in “down” years.  And guess what?  The “down” years often coincide with bad years in the stock market.  Because of these factors, I do not consider these bond “risk reducing” at all – I consider these bonds “risk seeking”.

So whats the big deal?  My issue is that you will often see “risk seeking” bonds occupying a portion of many portfolio managers “bond” holdings.

Lets take a look at a “robo advisor” portfolio I looked at recently.  This portfolio was intended to be of “moderate” risk – equal to 60% stocks and 40% bonds.  The problem with this portfolio is that half of the bond holdings were invested in junk bonds and emerging market debt.  If the stock market were to crash tomorrow, how do you think these “risk seeking” bonds would hold up?  I would bet terribly.  Take a look at junk bond returns and emerging market debt returns in 2008 to see for yourself.

Because this “robo advisor” (managing billions of dollars, by the way) has missed the “point” of bonds in the portfolio, their clients are really taking on much more risk than they signed up for.  This particular portfolio, although stated as a 60/40 portfolio, has nearly the risk characteristics of a true 80% stock/20% bond portfolio in my eyes.  Said another way, this portfolio has 80% of its assets in “risk seeking” vehicles – not the 60% you would guess from the stated “60/40” allocation.  Taking more risk works well in a “risk on” environment, but investors in this particular portfolio will have a rude awakening when we enter the next bear market.

Never invest in junk bonds or emerging market debt?  Wrong.  These asset classes may be good diversifiers and might add value to a portfolio.  We just need to think of these asset classes as “risk seeking”, versus the other types of bonds that are “risk reducing”.  If you want to have a 20% weighting in junk bonds and emerging market bonds (which may not be a terrible idea in the context of a diversified portfolio), then you would simply sell 20% of your other “risk seeking” positions (stocks, commodities, real estate, etc…) to maintain the intended 60/40 allocation.

Simply thinking of asset allocation in terms of stocks and bonds can lead to unintended consequences.  Each asset class has its own unique risk/reward characteristics, and for the most part, we can easily separate them into two categories: “risk seeking” assets and “risk reducing” assets.  Once you open your eyes to this separation of risk you will begin to see investing in a new light.

Charles Brown is a Portfolio Manager and Financial Advisor at M. Brown and Associates in Naperville, Illinois

**The above article is informational in nature only and is not a recommendation to buy or sell securities.  All information is gathered from sources believed to be reliable, but neither Charles Brown nor Ausdal Financial Partners, Inc guarantees the accuracy of the information.  All investments carry a degree of risk.  Individuals should consult with their tax and investment professionals before making changes to their investment portfolios.

***Securities and Investment Advisory services offered through Ausdal Financial Partners, Inc, 5187 Utica Ridge Road, Davenport, IA 52807 (563)326-2064. Member: FINRA/SIPC. M.Brown and Associates and Ausdal Financial Partners are independently owned and operated