Why You Need to Own Bonds
Written by: Grayson Blazek
When one thinks about portfolio diversification, bonds, in addition to US and International equities should be evaluated.
An investor may be tempted to overlook bonds altogether given that investing in equities tends to lead to higher overall returns (see Exhibit 1 below). So why include bonds in your investment portfolio? The answer lies in reducing the volatility of your portfolio, providing for short-term cash needs and helping you sleep better at night.
Diversification and reduced volatility
The purpose of allocating a portion on your portfolio to bonds is to reduce overall volatility. There is risk in allocating a large portion of your portfolio towards equities when markets are at high levels. By including bonds in your asset allocation, your overall portfolio risk is reduced given that bonds are not as highly correlated with equity returns and tend to act as a diversifier during market downturns (see exhibit 2 below). Additionally, by allocating a portion of your portfolio to bonds, this allow you to have funds in your portfolio available when stock prices are more attractive to increase your stock allocation.
Today’s Environment and the opportunities it presents
For the past thirty years, we have been in a falling interest rate environment (see Exhibit 3 below). From the all-time highs in the early 80’s, interest rates had fallen to near zero in recent years. This led to outstanding performance in the bond markets. Like equities, bull and bear markets tend to be cyclical. The difference being that while cycles in equity markets tend to last a few years, cycles in bond markets tend to last a few decades as rates can remain low for longer than people expect. For example, it took approximately 19 years for interest rates to rise from just below 2% in 1941 to 4.75% in the early 1960s.
Investing in a rising interest rate environment
Given that bond prices tend to fall when interest rates are on the rise, is now a good time to invest in bonds or should they be avoided? While in the short-term bond prices will decline, rising interest rates are a good thing for bond investors so long as their bond portfolio is adequately prepared. The further out on the duration scale you go; the more bond prices will be affected by interest rate moves. The duration of a bond is the approximate measure of a bond’s price sensitivity to changes in interest rates and is measured in years.
In rising interest rate environments positioning your portfolio towards bonds with shorter maturities, risk for loss of principal will be reduced. The reason for this is that as bonds mature, the principal is available to be reinvested at higher rates. So, while over short time periods, increasing rates can result in negative performance, over time, the benefit of higher interest rates compounds and results in longer term positive performance.
Risks of the Bond Market Index
So why not just invest directly into a bond index fund? As outlined in Exhibit 4 below, the duration of the index has extended over the last few years. Keeping in mind that the longer the duration the more sensitive bonds are to rising interest rates, the relative ‘safety’ that bonds typically bring to a portfolio has been diminished.
Since the financial crisis in 2008, the Aggregate Bond Index’s underlying composition, which was heavily weighted towards mortgage and other asset backed securities in 2008, has transitioned to US Treasury bonds in recent years. Traditionally, asset backed securities have a shorter duration than the longer-dated US treasuries which is one of the causes of the duration extension of the index.
Expected Bond Returns
Starting bond yields are highly correlated to future bond returns so with the bond market index yield in the low 2% range, index returns should align to that. How do you get higher returns? We don’t recommend reaching for return in the bond market as it should act as a stabilizer when the equity markets decline. That said, the bond market index composition is based on the percentage of bonds outstanding (see Exhibit 5 below). By buying what is a better value and not the highest weight may help increase your return over the index.
Additionally, corporations are taking advantage of the current environment and locking in low interest rates over longer periods of time. With bonds locked in at lower interest rates, coupons have decreased from over 5% in 2008 to just over 3% (see Exhibit 6 below). Together, these factors have culminated to fundamentally change the composition of the Aggregate Bond Index, and have resulted in an increase in the index’s risk level.
Finally, high quality bonds offer investors something of an emotional hedge against poor behavior. Not every investor is willing or able to have their entire portfolio in the stock market. There’s no use in trying to implement a risky portfolio strategy if periods of poor performance are going to cause you to not stick with it. Bonds can help by providing stability in the event of a stock market sell-off.
Even if bonds were to fall in a down stock market, it wouldn’t be nearly as severe. In this respect, bonds can act as a source of funds for either rebalancing into stocks at lower prices or for selling for cash flow needs. Ultimately, they provide the stability investors crave to alleviate the stress that volatile stock markets can cause.
Most Read IRIS Articles of the Week: March 19-23
Here’s a look at the Top 11 Most Viewed Articles of the Week on IRIS.xyz, March 19-23, 2018
Click the headline to read the full article. Enjoy!
Let’s pretend you are a US investor that wants to deploy some of your money overseas. You think international developed market stocks are attractive relative to US stocks, and you also think the US dollar will decline over the period you intend to hold your investment. — Chris Shuba
I had a chat with The Financial Times the other day, and provided lots of background as to why I don’t think cryptocurrencies are the choice of criminals. The comment that was reported was the following ... — Chris Skinner
During the tumultuous red and green gyrations of the capital markets this year have your clients anxiously called to ask: “What’s going on with my portfolio?” What do you do when the usually smooth ride in your luxury automobile becomes as bumpy as Mr. Toad’s Wild Ride in the Happiest Place on Earth? What does the average investor do? — Ted Parker
Inflation is a bad thing, right? It make things more expensive, right? For those of us of, let’s say, a certain vintage, we recall the runaway inflation of the late 1970’s and early 1980’s. So why does the Federal Reserve – in charge of managing the country’s currency and value thereof – actually try to create inflation? It’s called the inflation targeting and it matters to your money. — Bill Acheson
As you near your 60’s, your prime earning and saving years will transition into a period of time where you get to enjoy the “fruits of your labor,” a.k.a retirement. We call this segueing from accumulation to decumulation, the period when you will be drawing from your accumulated nest egg. — Dana Anspach
Exchange traded funds (ETFs) are popular vehicles for market participants looking to engage in thematic investing. Thematic investing looks to take advantage of future growth trends, including disruptive technologies. Given that forward-looking approach, stock-picking in the thematic universe is equally as hard, if not harder, than in traditional market segments. — Tom Lydon
It’s not enough for your salespeople to be product experts, they also need to be capable of having the kind of conversations that position them as business experts and even strategic resources. — Lisa Rose
Business growth doesn’t come from wishful thinking. As you know, it takes a lot of hard work. The growth of your business is not an option – it is a necessity. Coordinating the right mix of strategies to gain market share and improve client acquisition rates is essential to advance your firm in today’s economy. — Michelle Mosher
It’s undoubtedly true that investors’ financial security is no laughing matter, and this is reflected in the stolid, dour, reliable imagery and branding that is, by and large, the industry standard. This is hardly surprising—investors need to believe they’re placing their hard-earned money in the hands of experienced, trustworthy professionals. — Alexandra Levis
The number one question advisors ask when exploring a move to independence is how the economics compare to accepting a recruiting package from a major firm. It’s certainly a valid concern, because while the recruiting deals being offered by the wirehouses are down, it is still very possible for a top advisor to get a really attractive hard-to-pass-up offer. — Mindy Diamond
Municipal bonds might not be the first thing that comes to mind when you think of a sexy investment. They don’t typically command news headlines like the stock market or bitcoin. — Frank Holmes
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