Why would I ever want to hold bonds in my portfolio?
I’ve been asked that question many times over the last 28 years. Between June 2004 to December 2005, when the Federal Reserve raised the target rate 13 times in a row, resulting in lower bond prices. From 1995 to 1999 and 2003 to 2006, when bonds appeared to serve no purpose in portfolios than to dampen the double-digit returns stocks delivered. More times than not, bonds have been the underdog in investment allocations, and recent stock market returns followed by the Fed’s rate increase last week haven’t helped their cause.
But I’m here to make a case for bonds – the right bonds – in your portfolio.
Bonds are a resource for rebalancing when stocks are down. TAAG’s investment philosophy is anchored in asset allocation targets with rebalancing prompted by specific triggers. Even in years when stocks post positive returns, there are months when U.S. and overseas equity markets drop due to geopolitical and economic concerns.
This year, the surprise ‘Brexit’ result of the United Kingdom’s EU vote caused US stocks to drop significantly over a two-day period, providing us with an opportunity to sell bonds at higher prices, and purchase stocks while they were down. Equity markets were back to their pre-vote drop within 5 days, but without bonds and cash to use as a resource, the opportunity to buy stocks ‘on sale’ would have been lost. We’ve had similar opportunities during the Greek credit crisis, 9/11, the Great Recession, and others.
Bonds act as shock absorbers in times of market turmoil and fear. The Dow Jones Industrial Average was at 6,000 points on March 9, 2009, near the bottom of the Great Recession. After nearly 8 years of positive stock returns, resulting in a Dow approaching 20,000 today, that time feels like a distant memory. President-elect Trump’s promise of less government regulation and more infrastructure investment in the US has many anticipating a golden age for businesses, which is reflected in the run-up in stock prices since the election.
But there’s more going on in the world than our presidential transition. Syria, Turkey and the rest of the middle east deliver daily news about assassinations, civil war and anger. The growing nationalism in the US that was on display during our presidential race is being echoed in other countries around the world, and may affect our global relationships. The world is an unpredictable place, and while TAAG’s long-term outlook for stocks is always positive, there are periods of time when stocks will experience sharply negative returns for reasons we can’t foresee today.
Bonds can help you sleep better. It sounds facetious, but bonds can make your investment returns much smoother, so you lose less sleep due to worry. Bonds provide an interest income stream for retirees living off their portfolios, and a resource for cash when stocks are down. During severe market drops, even a small allocation to bonds in growth-oriented portfolios reduces the hole you must dig out of to get back to positive returns.
When losses are less severe, it’s less likely you’ll experience an ‘I can’t take it anymore!’ response to the negative drumbeat of the media. You won’t feel compelled to sell your stocks with the promise that ‘I’ll get back in when things look more positive.’ That bus left the station for many investors who sold out of stocks in 2009, and kept waiting for a good time to get back in.
Bonds play an important role in portfolios, but they must be the right bonds to do the job. Historically low interest rates delivered by bonds over the past 10 years have caused some investors to look for higher returns in high-yield and long-term bonds.
High-yield bonds are higher risk, which is why they pay a higher rate of interest in the first place. Their risk level causes them to fluctuate in value nearly as much as stocks, defeating the purpose of holding them as resources to sell when stocks are down. Between 2006 – 2009, many high-yield bond funds dropped significantly when their underlying investments came into question.
Long-term bonds, maturing in ten or more years, typically pay a higher interest rate, but carry a high risk of principal loss in a rising interest rate environment. The 30-year Treasury bond pays 3% today, but if interest rates climb due to proposed infrastructure investments in the U.S. and other factors, an investor holding a 30-year government bond would lose principal value quickly.
Holding individual bonds vs. bond funds can also cause problems for investors. A single bond is subject to the same risk of concentration as a single stock holding. A company that issues a bond might fall into financial difficulties and be unable to pay you back when the bond matures, or suspend interest payments before maturity if cash flow is tight. The bond may not be easy to sell before its matures, making it difficult for you to raise cash to pay expenses or rebalance your portfolio.
TAAG uses shorter-term, high-credit quality bond funds in our portfolios, providing our clients with more liquidity, less fluctuation in market value, and more of a cushion against the wider market fluctuations of stocks.
Today, bonds are the underappreciated asset class – the underdog of portfolios – but when markets are inevitably shaky, you’ll be glad they’re around.