With the prospect of rising rates in the US, and relatively weak run for fixed income in recent months, some now question the role of fixed income in a portfolio. Here I’ll explain why fixed income is still valuable.
Perhaps the most obvious point to be made is that bonds are generally believed to do badly when rates rise, which is scaring some away from the asset class. This has not been true historically. Bonds have historically performed relatively well during rate rises and this article discusses a recent book on the topic reaching the same conclusion.
Additionally, we should also remember that the Fed is not yet raising rates. The Fed is currently predicting a rise in the second half of 2015. Forecasts have generally been too early in predicting a rate increase over the past several years.
There’s a tendency to believe that bonds are expensive currently. It is certainly true that their yields are below historical norms, however, we are also in a period of low inflation. Importantly, though the valuation of equities is less obviously apparent, but one can argue that equities may be just as expensive as bonds in the US. This certainly appears to be the case given the US 10 year Treasury yields 2.4% and the dividend on stocks is 1.9%.
Both these valuation metrics are well below historical averages and close to all time lows, presumably reflecting high confidence in low and stable inflation in the coming years. Therefore, to avoid bonds in favor of stocks because of meager returns, may be shortsighted based on what informed projections of long-term equity returns are also forecasting. Note these apparently high US valuations for both stocks and bonds may be a reason to make sure your portfolio is internationally diversified.
One of the challenges in portfolio construction is that there are many sources of incremental return, but they often come at a cost of greater downside risk. This creates a role for bonds. For example, momentum investing, which is the strategy of holding past winners for a period of a year or less has performed well historically and generally beats the market, on average. However, it also comes with a cost in that if the market falls, then the strategy can do much worse than the overall market. Hence the strategy can make your returns worse, right at the point when they are weakest. A similar principle applies with several other market anomalies, for example selling out of the money put options can be profitable over time, but especially expensive in bad markets.
Against this disappointing backdrop for many investment strategies in weak markets, bonds have historically performed rather well. Government bonds benefit from a flight to quality effect that can occur in bad markets. So when markets do poorly, bonds can actually rise. For example in 2008 stocks fell 36% and the US 10 year Treasury rose 20%, in 2002 stocks fell 21% and the US 10 year Treasury rose 15%. Bonds don’t always rise as strongly as they have in recent market declines, but they do normally rise when stocks do poorly, and show lower volatility than stocks.
This matters because of the behavioral aspect to investing. It’s easy to believe that during bull markets you have a strong stomach for market declines and progressively notch up your willingness to take risk, however as we saw in 2008/9 many previously fearless investors will move to cash when a large market decline hits and they see red in their portfolio. This is quite understandable, but an unfortunate for investment returns. Fortunately, bonds can help make a portfolio more tolerable in bad markets. They do this by rising in value when equities are falling the most. This should help level portfolio returns, which in turn can help you stay the course and help your long term investment prospects. When you think of the benefit in terms of enabling you to stay the course in maintaining a portfolio, the returns from bonds in bad markets are potentially significant.
It should also be remembered that bonds are generally an extremely low volatility investment if held for the longer term. For example, if you hold a US Treasury 10 year bond for the entire 10 years, and there is no government default (which appears extremely unlikely) then you will earn precisely the payment promised when the bond was issued. This level of certainty is rare in other asset classes. Of course, changes in the market’s discount rate, can change the value a bond trades at in the interim, but if you hold the bond to maturity the cash flows will be entirely predictable.
Stocks virtually never have this same level of predictable cash flows because so much depends on earnings growth and dividend payouts and these can rise and fall by large amounts for a sustained period. This is why we believe bonds are particularly valuable for those with shorter time horizons. Certainly bonds have a lower return in most historical periods, but you are much less likely to endure a bad short term outcome with bonds than with equities.
As the chart helps illustrate, since 1928 the 10 year US Treasury bond has never fallen more than 12% in a calendar year and have had a positive annual return in more than 8 years out of 10, and again remember that some of those increases are coming when stocks are weak. Of course, there is a cost to this predictability in that the average return on bonds is generally lower than the average return for stocks. Owning bonds directly can be challenging and they can be tax inefficient, but there are solutions to both. Firstly using diversified ETFs such as the
So remember that the Fed is not raising rates yet, but historically bonds have performed well during rising rates. Predicting catastrophe for bonds would be well outside historical norms over past centuries and bonds, when the worst annual return was a 12% loss and the general rule of thumb that bonds will likely level returns if stocks are weak, and may do this better than most other asset classes. It appears bonds deserve a role in your portfolio.
See my bio for full disclaimer. Not intended to serve as a forecast, a guarantee of future results, investment recommendation or an offer to buy or sell securities.
