Do Bonds Still Deserve a Place in Your Portfolio?
Both equity and fixed income markets saw a return of volatility in a challenging first quarter due to the
Federal Reserve’s rate hike actions, the Russian invasion of Ukraine, increasing inflation, and a
pandemic that won’t quite subside. Despite seeing the largest swings in price, U.S. equities edged out
U.S. bonds in the first quarter thanks to a sock market March rally in late March.
Quarterly Market Summary
Past performance is not a guarantee of future results. Indices are not available for direct investment. Index performance does not reflect the expenses associated with the management of an actual portfolio. Market segment (index representation) as follows: US Stock Market (Russell 3000 Index), International Developed Stocks (MSCI World ex USA Index [net dividends]), Emerging Markets (MSCI Emerging Markets Index [net dividends]), Global Real Estate (S&P Global REIT Index [net dividends]), US Bond Market (Bloomberg US Aggregate Bond Index), and Global Bond Market ex US (Bloomberg Global Aggregate ex-USD Bond Index [hedged to USD]). S&P data © 2022 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. MSCI data © MSCI 2022, all rights reserved. Bloomberg data provided by Bloomberg.
Aren’t Bonds Less Risky?
As a brief review, bonds are essentially loans or “I.O.U.s” issued by a borrower – such as a government or corporation – and investors are basically loaning money by investing in bonds. Assuming the borrower makes good on their promise to repay, the investor typically receives their principal back, plus interest, when the bond matures. Because of these known interest and principal repayments, bonds are generally considered to be less volatile than stocks. Additionally, they’re often secured by the assets of the borrower. In other words, if the borrower were to go out of business, the lender or bond investor would be at the front of the line whereas stock investors would be at the end of the line, thus facing the highest risk of loss. The tricky thing about bonds is that their price can fluctuate – sometimes wildly – between when they’re issued and when they mature. This fluctuation is largely driven by current and expected interest rates for similarly rated bonds relative to the bond in question. Other factors go into the price of a bond such as the credit quality and rating of the bond (the perceived risk) but for this brief, I’ll focus mostly on interest rates.
Why Own Bonds in the First Place?
Investors typically own bonds for three reasons:
- They offer a relatively predictable income stream and have a known maturity. Said differently; you typically know what you’re getting and when you’re getting it.
- They tend to be preferred or favored in times of economic and market uncertainty as investors seek more predictable investment characteristics. Said differently; they can provide ballast to a riskier portfolio.
- In some cases, they can offer a return greater than the interest rate they pay. Said differently; there is the potential for capital appreciation (but as with all investments, the potential for loss, too).
Current Bond Market Challenges
The bond market is no stranger to challenges, just as stocks, real estate, Dutch tulips and other asset classes. Currently, one challenge before the bond market is that interest rates are beginning to increase after a decade of being held at or near zero. As a result, future interest rates are expected to be higher putting downward pressure on the price of existing bonds. Confused? Think of it this way; let’s say that today I buy a hypothetical bond issued by ABC Corporation paying 3% interest, and let’s assume it matures in five years. Let’s then say that tomorrow, ABC Corporation borrows more money by issuing more 5-year bonds but these bonds are issued at 4% because interest rates have moved higher. Which bond, as an investor or lender, would you rather own? Most people would prefer to earn 4% rather than 3% and so as a result, the 3% bond declines in price. This is referred to as interest rate risk.
In its March meeting, the Federal Reserve raised the Fed Funds rate from 0% to 0.25% and signaled they plan to raise rates six more times this year. This signaling has caused many existing bonds to trade lower as investors anticipate higher rates. While existing bonds are generally trading lower, it’s important to note that investors who put new money to work (or rebalance portfolios into bonds) are generally earning higher rates than before the announcement. For investors in funds that own bonds, managers of those funds may be able to deploy idle cash into these higher yielding bonds.
Another prominent challenge for most all investors, and especially bond investors, is that inflation has increased to levels not seen in 40 years. At current rates of inflation, and with relatively low rates of interest on bonds, investors may be earning a negative return after accounting for inflation (also known as a “real return”). While this is still true for investors in other assets that may have declined this year (e.g., stocks, real estate, etc.) it’s especially painful for many bonds investors – at least in the short run.
While no one can likely forecast where inflation will go from here with accuracy, I do think it’s worth pointing out that data from the Federal Reserve show that the breakeven inflation rate is roughly 2-4%, lower than the recently observed inflation figure of 7.9%. In other words, projected inflation is pointing lower in the future and so this recent spike in inflation could be short-lived. As investors, we often fall into the recency bias trap by extrapolating recent events into the future as if a pattern exists.
Why Continue to Own Bonds?
Given the current headwinds, why continue to own bonds at all? And why buy more bonds? Why not own other assets instead? These are great questions that warrant further investigation.
Going back to an earlier paragraph, investors should consider owning bonds to
1). generate income
2). provide ballast to riskier portfolio assets
3). potentially generate capital gains.
I would submit that all three reasons are still valid despite the current challenges (e.g., rising rates and inflation). Bonds are now generating higher levels of income and continue to offer the potential to diversify a portfolio and thus a less volatile experience relative to stocks. In the event rates decrease – or fail to increase as much as the future increases that are currently priced in – it’s certainly possible to see bonds increase in value.
Even at higher rates, investors may feel that bonds offer anemic returns. In an ideal world, investors would only put dollars into the highest returning assets – historically stocks and real assets like real estate – and they would invest with an infinite time horizon. However, for most affluent and high net worth investors (and many institutional investors such as pension funds) the priority is to ensure they have enough to live comfortably into and through retirement, with a secondary focus on capital growth. Many investors cannot afford the potential loss that is associated with a portfolio of risk assets such as all stock and real assets. Taking a chance investing in only riskier assets such as stocks is like driving in the fast lane; you may likely arrive to your destination faster, but you also increase the risk of a catastrophic accident getting there. Having part of a portfolio in bonds is like driving in the middle lane; it doesn’t feel as good at times, but it typically increases your chance of arriving to your destination in one piece, albeit a little slower.
I would thus argue the most compelling reason to currently own bonds is to provide ballast or a hedge to the riskier assets in a portfolio. This is increasingly beneficial as warnings of a potential recession are creeping into our headlines and news feeds. Recently, parts of the yield curve (a visual plotting of interest rates and maturities) have inverted which means shorter-term bonds are yielding more than longer-term bonds. The reason this is concerning is that you should, under normal conditions, receive higher yields for longer-term bonds. So called yield curve inversions have historically been a reliable indicator of an economic recession. Should we see a recession and extended market contraction, bonds are often favored for their lower perceived risk relative to riskier assets. If investors sell riskier assets and move into more predictable assets, such as bonds, you can imagine what that might infer for the prices of the bonds (read: they could very well increase).
Let’s assume that rates do continue to increase – does that mean bonds are a losing proposition? If we look back at past rate hikes such as 1994 when the Fed increased rates seven times. Bonds declined roughly 8% but then, a year later in 1994, bonds rebounded higher returning over 23%.
When equity markets turn volatile, prudent advice is normally to stay the course and ride out the volatility because over time, owning equities tends to be a rewarding endeavor. So why wouldn’t we expect the same to occur with bond investments?
Potential Action Items for Investors
When people lament that bonds aren’t attractive investments, I usually ask, “which bonds are you referring to?” The global bond market is roughly $123 trillion and just as there are different types of stocks you can buy, bonds come in all shapes and colors. You have, for example, government bonds, municipal bonds, sovereign debt, emerging market bonds, mortgage-backed bonds, floating rate bonds, corporate bonds, inflation-protected bonds, convertible bonds, and more. And within those categories, you have varying maturities and credit risk. On one extreme you have bonds issued by the U.S. government – arguably considered one of the most credit worthy lenders. On perhaps another extreme, you have a high-risk lender like Argentina, which defaulted on its new 100-year bonds just three years after issuance. In other words, there’s a wide world of bonds to choose from and as a result, you have a wide range of possible returns.
Listen to the “Experts” with a Grain of Salt
There’s no shortage of talking heads sharing their forecasts on interest rates and returns for various assets. For years experts have suggested a bond bubble was brewing (see here, here, and here, oh, and here, too) – but they’ve been wrong for nearly a decade! Here’s the takeaway; we could be in a bond bubble, but we won’t know until after the fact — and that’s true of stock, real estate, and other asset classes, too. As economic Nobel Laureate Eugene Fama pointed out: “For bubbles, I want a systematic way of identifying them. It’s a simple proposition. You have to be able to predict that there is some end to it. All the tests people have done trying to do that don’t work. Statistically, people have not come up with ways of identifying bubbles.” And for the billionaire investors on TV who offer advice, as good (or bad) as it may be, just remember – it’s almost impossible for them to know your situation, your risk tolerance, your goals and objectives. Many of these “gurus” are typically able to take larger bets because they’ve already made enough money to be comfortable, so if they’re wrong, the consequences are less meaningful. Not to mention, many of them are still running companies that profit from selling their fund, product, strategy, etc.
Avoid Market Timing
Perhaps most of all, investors should avoid trying to time interest rate hikes or put too much weight on what the Fed may or may not do. A transparent Fed is a relatively new concept – in the past the Fed used to change rates without advance notice. But just because the Fed forecasts its expected actions doesn’t mean they will become reality. In 2018, for example, the Fed was expected to raise rates multiple times…only to turn around and cut them multiple times in 2019. In other words, don’t “fight the Fed” but let’s not follow them blindly.
Beware Bond Alternatives
I regularly read articles that proffer alternatives to bonds. Like any profit-seeking investor, I read to see if there’s a new investment opportunity or an alternative worth further consideration. Without fail, unfortunately, I see suggestions for real estate investment trusts, high dividend paying stocks, closed end funds, complex option strategies, and the like. While nothing is inherently bad with these investments – what investors may fail to grasp is that loading up on these so-called bond alternatives may result in an increased risk profile. Again, bonds historically offer ballast to a riskier portfolio. Like riskier assets, bonds should be expected to cycle through good periods and bad. To try and outsmart the publicly traded capital markets is to walk a slippery slope – caveat investire. Until someone can tell me, with near certainty, what interest rates will do in the future, a diversified portfolio of global bonds still has a home in most portfolios.
Consider Your Goals
Each investor is different and thus has different needs. Investors should determine what rate of return they require to reach their goals and what rate of volatility they can endure, and they should then build a portfolio accordingly. Prudent advice suggests that if you have a shorter time horizon, you should be in less volatile asset classes (e.g., a higher allocation to cash and short to intermediate-term bonds, and less allocated to stocks). For investors with goals beginning decades into the future, they should consider a heavier allocation to stocks and other risk assets.
Please do not hesitate to contact our office with any questions or if we can be of assistance.
Jeff DeLarme, CFA, CFP®
The information in this writing has been prepared from sources believed to be reliable, but is not guaranteed by Raymond James Financial Services or DeLarme Wealth Management and is not a complete summary or statement of all available data necessary for making an investment decision. Any information provided is for informational purposes only and does not constitute a recommendation.
The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. Any opinions are those of DeLarme Wealth Management, and is not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions, or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of strategy selected individual investor’s results will vary.
Bond prices and yields are subject to change based upon market conditions and availability. If bonds are sold prior to maturity, you may receive more or less than your initial investment. Holding bonds to term allows redemption at par value. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise.
There are special risks associated with investing with bonds such as interest rate risk, market risk, call risk, prepayment risk, credit risk, reinvestment risk, and unique tax consequences. To learn more about these risks and the suitability of these bonds for you, please contact our office.
Investments in municipal securities may not be appropriate for all investors, particularly those who do not stand to benefit from the tax status of the investment. Municipal bond interest is not subject to federal income tax but may be subject to AMT, state or local taxes.
The hypothetical example used is for illustration purpose only and does not represent an actual investment.
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The Bloomberg US Aggregate Bond Index, or the Agg, is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States. Investors frequently use the index as a stand-in for measuring the performance of the US bond market.
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