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Stocks and Bonds: When to Choose Bonds Over Stocks

written by: Brian Nelson•edited by: Jason C. Chavis•updated: 5/18/2011

Whether to choose bonds over stocks or stocks over bonds is an important part of any long-term investing strategy. Get the stock to bond ratio right in your diversified portfolio asset class weightings. Why would you choose bonds over stocks?

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    Why Choose Bonds Over Stocks

    Any financial expert will tell you that over longer periods of time, stocks historically have out performed bonds. So, why would you choose bonds over stocks?

    One main reason to choose bonds over stocks is if the investor requires steady income. While dividend paying stocks can provide income, dividends can be changed at any time by the company. Bonds, however, have a specific rate of interest that they pay. This rate cannot be changed by the company through any means other than by defaulting on the bonds. Missing interest payments on bonds or defaulting on the debt altogether is an extreme measure, and one seldom undertaken by companies with any other options. The steady income provided by bonds is the main reason to choose bonds over stocks.

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    When Are Bonds Safer Than Stock Investments

    The first reason to choose bonds over stocks in your investing strategy is when bonds are expected to be less risky than stocks. Determining just when bonds will do better than stocks is not always easy. However, there are market indicators and economic signals that can point savvy investors in the right direction.

    The outlook for bonds in 2010, for example, is based upon how the economy moves on from the recession. How municipal bonds will perform depends a lot on how the states and governments that issued those bonds navigated their way through the real estate bubble insipired recession. The good news is that the crippling economic recession that left many states and local governments in dire straights, is easing as tax collections pick up from their recessionary lows. That makes municipal bonds a less risky investment than they were last year.

    However, how does the outlook for municipal bonds in 2011 appear? That answer is hazier thanks to the impending end of stimulus funds from the Federal Government. Without these economy boosting projects helping prop up local economies, tax collections could fall again. Worse yet, a lot of stimulus dollars went straight into the coffers of local governments, allowing them to avoid difficult cuts in certain services and programs like education. When that money goes away, state, county, and city budgets could all get a lot tighter.

    The much larger world of corporate bonds is also improving. The same recession that hammered the states pushed many publicly traded corporations right to the edge. While the banks and Wall Street firms enjoyed multi-billion dollar bailouts, most other companies had to resort to good old fashioned cost cutting. That is good news for bond holders who will find the issuers of their debt in a much better position to pay as revenues flow back into businesses with lower expenses.

    Of course, the biggest issue for bond holders to arise out of the 2008 recession is the debacle of the ratings agencies. Moody's, Standard & Poors, and Fitch all rated what are now known as "toxic investments" at their highest bond rating levels. That leaves investors in the difficult position of determing what level of faith should be placed in financial companies that were so easily duped by their Wall Street counterparts.

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    When Do Bonds Outperform Stocks?

    The other reason to favor bond investments over stock investments is that occasionally bonds will have better returns than stocks. Over the long-term, stocks always outperform bonds, but in the short-run, that is not always the case. When investors flee riskier stock investments for the relative safety of bonds, bond prices shoot up. In fact, one of the central concepts upon which diversification depends is that not all asset classes move in the same direction at the same time. While the stunning completeness of the real estate bubble popping sent all asset classes including stocks and bonds falling at the same time, it doesn't happen very often.

    Generally, as interest rates rise, bond prices fall. No one wants to pay $1,000 for a bond paying 4.0% when they can buy an equivilent risk bond paying 5.0% for $1,000. In order to sell the 4.0% bond, the seller must sell at a discount. Typically the discount is approximately the amount that would cause the bond to yield 5.0% based upon the lower price the buyer will pay.

    Conversely as interest rates fall, bond prices rise. In this case, when interest rates fall to 3.0%, bonds paying 4.0% are no longer being issued. The seller will therefore demand a premium that is approximately the amount that would make the bond yield 3.0% for the buyer.

    Therefore, the time to favor bonds over stocks as investments is when the investor feels that interest rates will be trending downward. Coincidentally, falling interest rates are most common when the economy stutters and business revenues and profits dry up, making their stock less valuable.

    With interest rates at historic lows, now is not the time to increase an investor's allocation to bonds. However, the volatility of stocks is clearly not going away either. For long-term investors, sticking with a carefully constructed diversified portfolio is still the best solution. For short-term investors, alternative income investments are looking more attractive.

    Until interest rates rise to some level that can be considered "normal" or otherwise sustainable for an extended period of time, bonds are unlikely to outperform stocks.

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    Image Credit

    Image from Microsoft Office clip art library.