What is the right bond weighting in a portfolio? It all depends on whom you ask. Managers of balanced funds often carry 60% stocks and 40% bonds or similar fixed-income. The usual reason? That’s the way it has been done for years. Call it custom more than reason.

But tradition — or policy inertia, if you like — is not a good enough reason to set a 40% bond weighting or, indeed, any other fixed ratio of bonds to other assets. That’s because there are a lot of variable factors that can affect choices when it comes to setting bond weightings.

Client or investor age, sensitivity to the business cycle, sensitivity to portfolio losses, the volatility of other components of the portfolio and administrative convenience and cost all have to be considered when setting bond weightings, says Caroline Nalbantoglu, a financial planner with PWL Advisors Inc. in Montreal. “That 40% ratio does not suit everyone. Some people need an income portfolio with more than 40% bonds and others with ample cash flow can get by with a lower bond weighting. There are people who are scared of stocks and others who are relaxed about them. Every investor is different. You just cannot go by the rule of thumb.”

Preparing for a downswing in stock prices has a cost. If bonds are held for long periods, there is going to be a significant opportunity cost in forgone equities gains.

Stocks, historically, have an average annual compound return of 8% in comparison to the 5% average annual compound return of bonds. The 40% bond weighting in balanced funds turns out to be an expensive way to reduce portfolio volatility if all of that bond weighting is not really needed.

There is no reason that 40% is right for everyone, says Dan Stronach, a financial planner who heads Stronach Financial Group Inc. in Toronto. “The fixed-income component has to depend on how much volatility the client can handle. You want to dampen portfolio volatility.”

For volatility management, the right measures are personal. The bond weighting must be worth the protection it provides. First, what is in the portfolio? If it is heavily weighted with volatile junior mines and micro-cap tech stocks, then equity volatility will be higher than you would have with a diversified equity fund with exposure to financials, mines and minerals, consumer discretionary, and so forth. Volatility will also be lower in a portfolio heavily weighted with mature companies that pay substantial and growing dividends that support stock prices. If the portfolio has income-producing stocks that have lower volatility or risk than the market, the need for bonds is far less than in the former case.

Investor age and money at risk are two ways of examining how an investor can handle portfolio volatility. For a retiree, income is likely to be made up of pensions and investment returns. The need to control portfolio volatility rises with the weighting of investment returns in the portfolio. An investor who gets 90% of retirement income from a defined-benefit pension plan can worry less about his 10% exposure to equity markets than an investor who gets 90% of his retirement income from his stock and bond portfolio, says Craig Allardyce, vice president and associate portfolio manager at Mavrix Fund Management Inc. in Toronto.

The client’s stage of life should also influence bond/stock ratios. Rather than thinking of the equity/fixed-income ratio as static, you can set a bond allocation that rises with age. A commonly used allocation rule sets the bond weighting at a level equal to the investor’s age.

For example, at 45, an inves-tor’s bond portfolio can target 45% of portfolio value with a ladder built on five-, 10-, 15-, 20- and 30-year terms. This kind of ladder has increasing sensitivity to interest rate changes. If the yield curve that maps out terms and interest rates slopes upward, then short bonds will tend to feed into the rolling maturities, picking up interest income and compounding it along the way. The 30-year term can be strips that lock in returns regardless of interest rate changes.

This is an example of a rolling ladder that will automatically boost bond value over time. Weight can be added by buying more bonds or reduced by taking money out of bonds as the rungs of the ladder mature.

@page_break@The kind of bonds or fixed-income exposure investors buy will be critically important to how this rolling ladder of bond weights fulfills their needs. Conventional bonds produce cash via coupons and maturing principal. Bond funds may produce monthly or annual distributions that combine interest and capital gains. Bond exchange-traded funds tend to produce income but limit capital gains and losses.

Some bonds are not appropriate for setting up bond portfolios that adjust to age. For example, inflation-linked credits such as Canada’s real-return bonds do most of their work on paper and limit realizations of inflation-compensated value to maturity or sale of the bonds, Allardyce says. What’s more, RRBs tend to be lightly traded and, for that reason, are not as efficient a counterweight to moves in equity prices, he adds. For the investor who wants to stabilize asset values on a current month or year basis, conventional bonds or a monthly-pay bond fund works far better than RRBs or bond ETFs.

Administrative cost and benefit are the last variables that have to be considered. The bond portfolio we’ve laid out is largely passive. There is no suggestion that it be managed to beat stocks or any bond index. But a passive portfolio, especially one built on a ladder of maturities, tends to reflect the market rather than outperform it. There is a place for managed bond portfolios if the cost is manageable. These days, bond portfolios have average management expense ratios of 1.8%. For an asset class that may just settle for the 5% gross bond coupons as its return, that fee is excessive. For a long-term bond investor, a fee-
efficient bond fund is essential.

“Structured correctly, a bond and equity portfolio can efficiently build and stabilize returns,” Stronach says. “The idea of a 40% bond allocation in a ‘one size fits all’ balance amounts to a cheap suit when there’s custom tailoring that can be had for the same price.” IE