These days, bonds are getting a bad name. Stock markets are off to a tremendous start in 2012, dividend stocks are outperforming, and not surprisingly investors are losing their confidence in government issued bonds. There are three main reasons why investors are spooked with bonds. First and foremost, are the sovereign debt woes in Europe and the antics of the U.S. government to raise the debt ceiling, which sent ripples around world markets last August. Second is the global and record low interest rate environment, with the potential threat of increasing rates. And third of course, is the low yield on government bonds versus the yield on dividend stocks.

The Shift to Dividends

As a result investors have lost confidence in their governments (bonds) and turned to corporations (stocks) for higher returns through dividends. For the first time in decades, investors were even avoiding German bonds and Germany is one of the most economically stable countries in the world. Not surprisingly, many investors now have more confidence in the global conglomerates than they do in their own governments. But it never used to be that way. Government bonds were always viewed as more stable and a safe harbour in times of crisis.

The move to corporate bonds and especially dividend stocks has certainly been noticeable over the last few years. I’ve certainly been one of those investors riding that wave. Investors who have embraced dividend stocks have also been well rewarded, with increasing share prices and regular dividend income. In this era of low interest rates, the yields of dividend stocks have outpaced the yields on government bonds. But if you’re only looking at bonds from a yield perspective, then you’re missing the big picture. Let’s look back at 2008.

Looking in the Rear View Mirror

Driving and investing are much the same; you still need to keep moving forward. But you also need to look in the rear view mirror once in a while, to remind yourself where you’ve been. I’m reminded of recent times in 2007 to 2008 when stock markets were also doing well, and investors began selling their underperforming bonds to buy rising equities.

Many investors in 2008, even in their 50’s and 60’s, ended up with portfolios that had equity allocations above 80% or higher. Part of the reason was markets had been steadily rising for years (since 2003), so investors became blinded to the fact that markets move in both directions. Investors felt positive about stocks, but negative with underperforming bonds, and thereby increased their equity exposure. I covered this in a post nearly a year ago, Asset Allocation: Part-1 Risk Assessment . Yet no one could have possibly known the trouble that was looming ahead. Holding bonds through the financial crisis of 2008 and 2009 was exactly the right thing to do. It was also profitable.

Knowing what you know now, and you could turn the clock, would you have sold all your bonds and bought stocks in September 2008? 

Most investors would answer a definitive NO to a question like that. Yet at the beginning of 2012 we are also faced with a very similar investment climate to late 2008. Many investors are once again selling their bonds, buying rising equities (including dividend stocks), and throwing asset allocation out the window. So why are bonds and asset allocation so important?

There’s more to Bonds than Yield

One of the problems, is investors don’t realize that bonds and stocks are inversely correlated . and work together in a portfolio. That means when the prices of stocks decline, the prices of bonds usually increase, and vice versa. Comparing bonds to stocks, instead of understanding these are two different types of asset classes, is one mistake investors make.

Many investors also look at bonds solely in terms of yield. When you look at a bond’s YTM (Yield to Maturity) which is its worst case scenario, it’s not hard to understand why. Currently a 1-5 year Canadian Govt. bond ladder (Claymore CLF ) is only offering a YTM of 1.3% (although the coupon distributions are much higher). With little potential for capital appreciation, dividend stocks certainly look a lot better. But throwing away your safety net (of bonds) while markets are on a tear (stocks) is a recipe for disaster. We only have to look back to the financial crisis of 2008 and 2009 to see the results of an all equity portfolio.

There’s a reason why successful and established investors diversify their portfolios between stocks and bonds and big pension funds employ asset allocation as well. Bonds are not about high returns, they never have been. Bonds are about providing you a cushion, in times of market turmoil. And for that stability you also get a modest income in return.

Why You Still Need Bonds

I realize some investors choose 100% dividend stock portfolios, and these are my favourite blogs to read. But these guys and gals are not ordinary investors. They are fully aware of the associated risk and volatility they are taking, in return for the dividend income.

But for the average investor loading up all out on dividend stocks, is still loading up on equities. That’s fine if you’re a seasoned investor, and you have the stomach and discipline (as well as the cash) to buy on the dips. But if you’re new to investing a 100% equity portfolio could give you a big slap in the face. When markets turn sour, they turn quickly.

It’s easy to say “I can handle the volatility” or “I will buy and top up the dips”. But when your portfolio plummets 30% to 50%, where are you going to get the cash to top up? In times like these bonds not only give you a cushion and a soft landing, they also provide you with working capital to buy cheap stocks on sale. This is a point bestselling author Andrew Hallam makes so well (covered in Part-2).  Across my portfolio, bonds are my insurance against market volatility. This was readily apparent for me last August when markets tumbled quickly, and my stocks were down over 15% in couple of days, yet my overall portfolio remained intact. I wrote a few posts on the topic that month, including Keep Calm and Steady .

In Part-2. I’ll look at the threat of rising interest rates on bonds, why the returns on bond ETFs and Bond Funds are better than investors realize, and how to leverage the power of bonds in a declining market.