Are Bonds Different From Stocks?

A few years ago, stocks were the most sought-after asset class. Demand for stocks lifted several major indexes to all-time highs before their ensuing decline. Meanwhile, other classes were overtly shunned, but eventually they were recognized.

Today, which asset class is the most highly regarded? For the past three years, bonds have been among the top-performing asset classes. The demand for bonds has pushed their prices higher and their yields to 40-year lows.1

Just as stock prices continued higher for several months before reversing their pattern, interest rates could also reverse their pattern. Should interest rates rise, bond values would decline.

Investors need to be clear on their objectives for owning bonds. The primary reasons for owning bonds are to: 1) supplement current income; 2) reduce portfolio risk; 3) and preserve capital.

Declining interest rates have driven money-market rates lower. CDs and bonds typically pay higher rates of interest than cash accounts. Consequently, many people purchase various fixed instruments to increase their current income.

Next, owning bonds is a way to reduce the risk and enhance the return of your portfolio. Often, bonds will produce positive returns in years where stocks decline, and vice versa. By owning some of each (stocks and bonds) in proportion to your level of comfort, you see fewer dramatic changes to the total value of your portfolio.

Finally, while the price of a bond will fluctuate during its lifetime, its principal is returned at face value upon maturity. This feature helps to preserve capital depending on the strength and security of the issuer. Bonds purchased at a premium, however, will actually decline to their par value by maturity.

While the first two reasons for owning bonds are perhaps most universal, the third is the one with which you should be most cautious. While you may enjoy higher-interest income today, bond values may decline in the same way that stocks did only a few years ago.

Scott Butera is a Financial Consultant with Smith Barney.  Smith Barney is a division of Salomon Smith Barney Inc. Questions are encouraged at 543-0316 or at scott.m.butera@smithbarney.com.

1Source: Salomon Smith Barney United States Fixed Income Research, Bond Market Monthly.

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