Common wisdom says bonds are a safe haven from stock market turmoil. Does that mean you should buy bonds if that turmoil comes from recession or inflation?

Complicating the situation is the fact that there is no one-size-fits-all-situations bond. The Treasury Department issues bonds, so do corporations, municipalities and banks. There are short-term bonds and long-term bonds; bonds with pristine credit ratings and junk bonds.

Remember, while bonds may protect you in hard economic times from the deep dives that stocks sometimes take, there is no guarantee you won’t lose money. With bonds, you can get hurt while standing on the sidelines.

Stability versus volatility
It’s a given that most people, especially as they near retirement and need to reduce volatility in their portfolio, should have a smattering of bonds for stability and to provide fixed-income.

The ratio of bonds to equities and cash depends on your needs and your risk tolerance. We won’t specifically address allocation in this article, but we will try to provide some guidance for when it’s appropriate to load up a bit more on your bond allocation.

Cash, U.S. bonds and foreign bonds
David Marotta, president of Marotta Asset Management in Charlottesville, Va., includes three asset classes in the stability portion of his clients’ portfolios.

The first is “short money,” comprised mainly of money markets and, occasionally, short-term CDs; assets that mature in less than two years. Second is U.S. bonds, and the third is foreign bonds.

“Short money has probably been the riskiest investment over the past couple of years,” says Marotta. “The dollar has dropped in value and its buying power has dropped tremendously. By proxy, the second riskiest investment is U.S. bonds. They’ve appreciated some in the recent market downturn, they’ve paid a little bit better interest rate, but in terms of purchasing power, they’ve been one of the worst investments in the last two years.

“Foreign bonds do the best during a recession and during inflation. During a recession, the bond category as a whole will do well, but during inflationary times, the U.S. dollar is dropping in value. Your foreign bonds are going to get both the good return you get in a bond portfolio during a recession and an extra kick because the value of the U.S. dollar is dropping.

“When the dollar drops, your foreign bonds are going up in value because they’re invested in foreign currencies, which aren’t being devalued as much as the dollar. When you invest in foreign bonds in this mode, you want to invest in unhedged foreign bonds.”

For example, a financial institution may be offering a CD that pays interest at 10%. If the institution does not compound interest, you will receive 10 percent of your investment as interest income at the end of a year.

But if the institution compounds interest every three months (quarterly compounding), you will earn an interest rate of 10.38%. If the institution compounds interest monthly, you will earn 10.47%. And if it compounds daily, you will earn 10.52%. For a $10,000 deposit, this is an extra $52 in interest that you earn.