I hate bonds. I really do. They are most vulnerable to higher-than-expected inflation, and they offer no opportunity for growth. Unless you intend to actively trade it, the yield you secure when you buy the bond is the yield you will get for its entire life.
But this stability is precisely what makes bonds a necessary evil, even in a low-yield world. Bonds play the role of portfolio stabilizer, and they can be used in a dynamic rebalancing strategy.
What do I mean by this? Let’s say your portfolio’s target allocation to bonds is 40% (That’s too high for my liking, but it’s considered the industry standard). If the stock market takes a short-term nosedive, you can sell off a portion your bonds and use the proceeds to buy stocks and rebalance. Likewise, if the market goes on a massive bull run, you can sell off some of your appreciated stock and buy bonds. The result is that you are constantly buying low and selling high.
Of course, this strategy works a lot better when bonds pay a respectable yield. Even after the recent taper scare, the 10-year Treasury still yields less than 3%.
My advice? If you need bonds as a portfolio stabilizer, buy individual bonds if possible and not bond funds. Bond funds are assumed to be perpetual, and returns will be terrible in a prolonged period of rising rates. But an individual bond held to maturity has no interest rate risk.
Also, try to stay shorter-term on the yield curve. If you believe yields are going higher, a bond with a shorter maturity will give you the opportunity to reinvest sooner and at a higher rate.
Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. As of this writing, he was long AMJ, JNJ, NNN, O, VIG and WMT. Click here to receive his FREE 8-part investing series that will not only show you which sectors will soar but also which stocks will deliver the highest returns. The series starts November 5 and includes a FREE copy of his 2014 Macro Trend Profit Report.