This year has been a challenging year for bond owners as interest rates rise. The Bloomberg US Aggregate Bond Index, the bond’s market version of the S&P 500, is down -16.61%.
So why own bonds at all? The value proposition bonds are that they tend to provide income, diversification, and provide liquidity. Despite the historically poor start to the year, we think the value proposition for core bonds has actually improved.
Income
Bonds are arguably now a little more attractive. Starting yields on most fixed income asset classes are near the highest we’ve seen in over a decade. One year ago, the 10-year Treasury yield was under 2% and now it is around 4%.
Bonds prices will continue to fluctuate depending on the movement of interest rates. Currently the bond market is pricing in another 0.75% hike in November and 0.50% or more in December. Anything above or below could impact the prices of bond prices.
However, investors who hold a bond to maturity (when it becomes due) get back the face value or “par value” of the bond. The day-to-day price fluctuations have no impact on your investment. You will have locked in the yield for the duration of the bond and get paid back your initial investment at maturity.
Diversification
When bonds are used in combination with stocks, they tend to reduce the risk of the total portfolio. Stock and bond returns tend to diverge. Bonds can look their best when stocks are at their worst. For example, U.S. bonds were up 2% while the U.S. stocks were down 23% on April 1, 2020.
Though the S&P 500 has since recovered, this example illustrates how bonds can add value during market panic.
But as we have seen this year, bonds have downside risk too. Bonds prices have an inverse relationship with interest rates. This means that when interest rates go up, bond prices go down and when interest rates go down, bond prices go up.
For example, if you purchased a bond paying 1% and rates rise, that yield doesn’t look as attractive when new bonds are paying 3%. The longer until the bond is repaid (matures) the more its value would fall to a rise in interest rates.
To minimize your risk, consider concentrating on bonds that have short-term to intermediate term maturities. The safest bonds are issued by the government or investment grade companies.
Liquidity
Bonds offer a more predictable income stream than stocks. Owning bonds is the equivalent of loaning money. In return for lending, you expect to receive not only your money back but also interest payments along the way.
Our basic principle for building a bond portfolio is to match the duration of the portfolio with the time horizon of the goal. For example, if you need money in two years, a bond with a duration of two year would be ideal. This is to help limit unnecessary risk. Long duration bonds will have more interest rate sensitivity.
Treasuries and other investment grade bonds offer the best “creditworthiness” and lower chance of default. Treasuries are backed by the full faith and credit of the U.S. Government making them a safe and popular investment.
Bottom Line
In recent years we have limited our bond exposure as yields were so low. However, with rates rising to the highest levels we have seen in over a decade, we have begun to see some opportunities.
Sources: Disclaimers
Bond Market Fed Funds Rate Probabilities from CME Group
Benefits for Owning Bonds from Investor.gov
U.S. Stock and Bond Return from Ycharts.com
Please consult your financial advisor regarding your specific situation. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for specific individualized tax advice.
All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.
