Investors look to bonds as a way to protect their portfolios from the risk of the stock market. But for some time, many professional investors have seemed more concerned about risk in the bond market than the potential for a stock market reversal, and some of their advice runs against established asset allocation principles that investors have used for decades to plan their portfolios.
Why bonds are important
If you've ever set up an investing plan for long-term goals like retirement, you're used to seeing bonds play an important role in achieving those goals. Typically, a portfolio for a financial goal that's still well in the future tends to be stock-heavy, with relatively little exposure to bonds and other fixed-income investments. As the goal approaches, however, allocations to bonds usually increase, giving up the appreciation potential of stocks for the reduced volatility and greater certainty of payout that bonds provide.
The combination of extremely low interest rates and trouble in certain areas of the bond market has led several financial advisors to trim bond allocation recommendations for their clients. In particular, BNY Mellon and Barclays have cut bond allocations by a quarter to a third. Some independent advisors have even eliminated bonds entirely from their client portfolios. With stocks at multiyear highs, is cutting back on bonds now an example of the worst possible timing?
Making the move away from bonds
The idea of moving conservative investors away from their long-held bond allocations may seem completely counterintuitive. After all, in theory, bonds are less risky than stocks. When you look at the hierarchy of a company's capital structure, bondholders have a higher rung on the ladder than stock investors. If a company goes bankrupt, shareholders have a high probability of losing everything. But often, bondholders will get a significant portion of their investment back. For instance, after General Motors
But bonds are definitely not free of all kinds of risk. Even Treasury bonds, which many consider completely free of default risk since they're backed by the full faith and credit of the U.S. government, can fall in value substantially when interest rates rise. That's a big part of why the Vanguard Extended Duration Treasury ETF
One reason why buying bonds makes little sense right now is that the reward you get from owning bonds doesn't justify the risk. Consider: The iShares Barclays 3-7 Year Treasury ETF
On the other hand, some parts of the bond market have fallen far enough that their potential future returns may be giving you enough reward to justify investing. Municipal bonds, for instance, have dropped recently as many have expressed fears about whether state and local governments will be able to meet their obligations. But with many muni bonds paying higher rates than comparable bonds despite their paying tax-free interest, tax-averse investors are paying greater attention to the space. The aptly tickered PIMCO Intermediate Muni Bond Strategy ETF
To eliminate interest rate risk entirely, one reasonable solution may be simply to use high-yield savings accounts. Short-term Treasuries pay next to nothing -- SPDR Barclays 1-3 Month Treasury ETF
Make the smart move
In the long run, you don't want to give up on bonds forever. But with bonds potentially poised to fall, assessing and adjusting for your risk makes sense. Making moves to protect yourself makes sense if you're exposed to greater risk than you can handle.
Fool contributor Dan Caplinger averts risk like a pro. He doesn't own shares of the companies mentioned in this article. General Motors is a Motley Fool Inside Value recommendation. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy saves the best for last.