Does it still make sense?
With Treasury yields firmly hovering near 2020’s all-time lows, the looming threat of inflation, and a Federal Reserve that recently began its long march toward policy normalization, investors may be wondering whether investing in bonds is still a wise choice.
While the modest yields offered these days are unlikely to inspire the levels of enthusiasm they once did, bonds remain an important piece of a well-constructed investment portfolio.
Any Port in a Storm
Of the many benefits bonds provide in an investment portfolio, perhaps the most crucial is their stability.
After a year and a half in which nearly every asset’s performance chart can be described as “up and to the right,” it can be easy to forget that stocks do suffer losses from time to time.
The occasional debt ceiling showdown notwithstanding, government bonds are effectively free from default risk. While changes in interest rates may cause temporary losses on the bonds in your portfolio, these losses are vastly less severe than in equities or other risk assets. In fact, since 1997, a portfolio of 10-year Treasury bonds has had an annual total return of -5 percent or worse only five times: In 1969, 1994, 1999, 2009, and 2013. By contrast, there have been 80 times where the S&P 500 index of stocks has dropped by that much or more in a single day.
Beyond simply making it tougher for some of us to sleep at night, the higher volatility that comes with an over-allocation to risky assets can create a major hurdle to the long-term success of an investment portfolio. Because returns do not compound linearly, losses will hurt more than gains will help. A 10 percent loss in one year will require an 11 percent gain just to break even, while a portfolio that loses 20 percent will need to earn 25 percent before it is back to where it started.
For investors in their post-retirement phase who may be relying on their portfolio to fund their living expenses, the adverse effects of volatility become further amplified. The same dollar amount of required cash flow grows to represent a larger and larger portion of the portfolio assets during periods of market selloffs.
The Only Free Lunch
Beyond simply exhibiting low historical volatility, fixed income such as bonds can reduce the risk profile of a portfolio through the benefits of diversification.
Famously called “the only free lunch in investing,” diversification is a vital feature of a well-managed investment portfolio. Diversification is the principle that by combining investment assets not impacted by one another or investment assets that tend to react in opposite ways, the volatility of the resulting portfolio will be lower than the average risk of the portfolio parts.
To illustrate this effect, consider three hypothetical portfolios: 100 percent diversified Large Cap stocks, 100 percent intermediate treasury bonds, and a 50/50 blend of the two. During the 20-year period from 2000 to 2020, the all-stock portfolio would have exhibited a standard deviation – a commonly used measure of investment risk – of about 15 percent. The bond portfolio in those same two decades exhibited a deviation of 4.5 percent. Averaging the two results, it might seem like the blended portfolio would have had a standard deviation close to 10 percent based on those two percentages. However, because of the diversification benefit provided by combining the two types of investment assets, the actual volatility was only 7 percent, a ‘bonus’ reduction in risk of nearly 30 percent!
Don’t Fear the Reaper
One objection we sometimes hear about keeping bonds in a portfolio is that the returns we have experienced have been the result of a 40-year decline in interest rates. The logic goes that this lowering interest trend is all-but-certain to reverse itself now that we have been pushed against the very lowest rates can go. However, neither economic theory nor data support this idea of returns resulting from declining interest rates. As bonds march toward their final value and yield (maturity), bond prices move toward that value. This adjustment overpowers interest rate impact and eventually forces a bond price to match the value printed on its face. Interest rate changes tend to be a wash throughout the life of a bond.
Even in a scenario where an investor does not hold a specific bond to maturity but rather buys and sells holdings within a portfolio over time – say, for example, by investing in an intermediate term bond fund. The yields will continue while the price will not change dramatically – the yields will likely offset the price. To see this effect in action, we can compare the total return of a bond mutual fund over time. For example, since 1980, the Fidelity Investment Grade Bond Fund – one of the oldest Fixed Income mutual funds in the world – has delivered a total return of more than 1,500 percent. Yet its price has increased by less than 15 percent. As you can see, even though the interest rates have been decreasing in recent decades, they have not had the effect of increasing bond prices commensurately.
There are some who believe they should avoid bonds, for the time being, thinking that as interest rates begin to rise, the value of the bonds will decrease. But there is no reason to be overly concerned. Rather than causing crippling permanent losses to you as a bond investor, a period of rising interest rates would at worst delay some of the bond returns an investor may earn over time.
By waiting to invest until after rates rise, however; investors are hoping they can predict the timing and path of future interest rates. Not only that, but also timing it so well they would make up any bond yields lost in the interim. The likelihood of being successful with that timing is slim and extremely unlikely, and not worth losing out on the bond earnings over the timing you may be avoiding bonds.
Bonds help bring stability, support diversification, and yield over time. It’s natural in such a low-interest rate environment to question the value of bonds in your investment portfolio, but concern about interest rates should not outweigh the importance of that stability and diversification in your investment portfolio.
If you have further questions about bonds, investing, or other financial savvy strategies, Domani Wealth’s team of highly credentialed advisors is at your service. We’re always glad to start a conversation, and can help answer your questions and concerns in language you can understand. Give us a call today at 1-800-855-5455 or email [email protected].