Is it time to forget what you learned about bonds?

The stock market has had a wild ride this year and more turbulence could lie ahead, what with a rancorous presidential election nearing and possibly more economic damage if a second COVID-19 wave hits.

But it might be the bond side of your portfolio where surprise risks lurk.

Bond yields have dropped so much in recent years, especially on government debt, that their income and diversification benefits are questioned.

U.S. Treasurys and other government bonds now yield less than what you can get from many dividend-paying stocks, and they might not cushion a portfolio from stock-market setbacks as you might expect. A traditional portfolio mix allocated to around 60% stocks and 40% bonds could prove disappointing.

“What’s the rationale for bonds when yields are close to zero or even negative?” asked Nicolas Rabener of Factor Research in a blog for the CFA Institute, an investment-professional organization. “It’s simply an asset class with no positive expected returns.”

Bonds are less volatile than stocks, of course. But most of the arguments in favor of including bonds in a diversified portfolio, he noted, are based on the past four decades or so, when a lengthy, sustained decline in interest rates made them appealing. Bond prices rise when rates decline, boosting their returns. But prices fall when rates rise, which appears the more likely scenario going forward.

Rethinking investment basics

The historic relationship between stocks and bonds is a fundamental building block of modern investment theory that helps shape decisions such as how to allocate investment dollars, noted Bank of America Securities in a report. But that relationship is changing, raising the question of whether the traditional investment mix of 60% stocks and 40% bonds is “dead,” the report said.

Not everyone holds 60% of their investments in stocks (including various subcategories such as small companies or foreign stocks). Nor do they hold 40% in bonds including Treasurys, corporates, municipals, foreign debt and so on.

Rather, 60/40 is just one prominent rule of thumb. Another is holding a percentage equal to 100 minus your age in stocks, which would work out to 40% in stocks and 60% in bonds if you are age 60, for example. Regardless of the model, the idea is to include bonds with your stocks to dampen volatility and increase income.

But the 60/40 rule, among others, is being questioned now because bonds might not hold up their end of the bargain. Yes, stocks might be overvalued, but investors expect risks with them. They aren’t so accustomed to dangers on the fixed-income side.

Risks for bond investors

The Bank of America report cited three major risks for bonds that could undermine a traditional 60/40 or similar allocation. One is that low yields translate to less income and make bonds more risky. Lower-yielding investments tend to have more volatile prices — that’s one reason a speculative technology stock that doesn’t pay dividends will bounce around more than, say, a utility company.

Another danger is that the stock and bond markets are moving more in sync than historically has been the case, lessening their diversification benefits. In other words, when the stock market drops, bonds might fall too (though probably not by as much).

A third concern cited by Bank of America is that many large institutional investors are heavily concentrated in low-yielding government debt following their lengthy, multidecade rally to date. When that trend reverses, these big investors could sell out of their bond positions quickly, undercutting prices.

Yields have compressed across the bond world, but categories other than government debt still offer higher payments and thus could be more attractive options. The Bank of America report recommended alternatives including short-term high-yield corporate bonds or funds, municipal bonds and bonds issued by foreign governments, especially in developing nations.

But these other bond categories, while paying higher yields, come with default dangers or other risks you won’t find with U.S. government debt, so there are trade-offs.

Are dividends the answer?

Bank of America also cited dividendpaying stocks as a way to fill the yield void. For example, a select group of “dividend aristocrats,” or large corporations with a history of increasing their dividend payments, are yielding about 2.7% on average.

Robert Wyrick, chief investment officer at Post Oak Private Wealth Advisors in Houston, said he doesn’t hold bonds in client portfolios. Rather, he focuses on stocks, complementing these holdings with put options on the Standard & Poor’s 500 index for downside protection. (Put options will rise in value if the underlying asset, such as the S&P 500, falls in price.)

For yield, he likes various dividendpaying stocks and funds that hold them, though he cautions that dividend stocks typically will bounce around more than bond prices. “You have to put up with more volatility than in a bond portfolio,” Wyrick said.

But dividends also have a better chance of growing over time compared with a bond’s interest payments, which typically are fixed. Many corporations strive to boost these payments over time. “You don’t often see dividend decreases,” he said.

Low-rate drawbacks

The long decline in interest rates has helped homebuyers and other borrowers, but it has caused stress in other areas. State and local government pension plans, for example, now are generating full-year returns in the range of 1% to 4%, increasing pressure on municipalities to contribute more money to these programs, reported Moody’s Investors Service. That’s below their target returns of around 7%, and declining rates largely are to blame, Moody’s said.

The unattractiveness of Treasury bonds and other government debt in today’s low-yield environment should have you reviewing your portfolio and investment outlook:

● Be prepared for losses on bond holdings if rates rise, though these setbacks could pale compared to a possible stock-market reversal.

● Understand the types of fixed-income investments that you own, including what’s in your bond funds.

Consider shifting more toward money market funds rather than bonds. Money funds yield next to nothing, but their prices won’t drop if rates start rising.

● View Social Security as part of your fixed-income portfolio. Social Security retirement benefits provide bond-like income, but without the same risks.

● Think about dividend-paying stocks to replace or augment your bond income.

There’s nothing especially timely about the bond-market scenario right now. Alarms have rang for several years about rising risks in the event of a sustained reversal of interest rates, and these warnings have proven premature.

But at some point, it seems all but inevitable that the bond-market tailwind will turn into a headwind. Be ready for that.