Contributed by: Angela Palacios, CFP®, AIF®
Through thoughtful financial planning, The Center wants to make sure that you achieve your goals regardless of what markets are doing for short periods of time. We are often asked why we would want to own bonds in a portfolio (especially now with interest rates at all-time lows!). While equity markets generally provide positive returns, there are still periods when they do not.
By their nature, stocks are better than bonds at providing investment returns as there is more risk involved in investing. There is no promise to repay your principal or interest along the way. However, while stocks might be better at providing total returns, bonds can provide returns more consistently because of these “promises”. If we were only focused on investment return, our portfolio would reflect 100% stocks. However, for most investors it still makes sense to continue holding bonds…here are a few reasons why!
Reason #1: To support a withdrawal strategy
One of the worst-case scenarios could have been retiring right before the Great Recession (late 2007). What if you had retired right before this scenario and needed to withdraw money from your portfolio even as markets corrected? Owning bonds during times of stress means there is a bucket within your portfolio that you can live on – perhaps for extended periods of time if needed – without having to touch stock positions that are down (they can even provide funds to deploy into equities opportunistically or through routine rebalancing). Using bonds as your source of income during this time (both the interest and selling bond positions) allows the equity positions a chance to rebound (which usually happens as we have experienced in the past).
Reason #2: Less Downside Capture
If you capture less of the downside it usually won’t take you nearly as long to get back to your “break-even” or back to where your portfolio value started before equity markets correct. The below chart does a great job of showing how this looked after the Great Recession. It shows the dark blue line [a portfolio mix of 60% stock(S&P 500) and 40% bonds (Barclays US aggregate bond index)] recovered nearly a year and a half earlier than a portfolio holding just stock.
JP Morgan Guide to the Markets
Reason #3: Better Investor Behavior
Never underestimate the shock of opening a statement and seeing a swift downturn in your nest egg! An allocation to bonds can potentially really assist your portfolio in this aspect as shown by the chart above. If you look at the February ’09 point on the chart and cover up everything to the right of that, ask yourself “Is the “green line” experience something you could shrug off and continue holding or even invest more at this point?”. Now it is clear that you should have held on to your stock positions but in those moments back in 2009, we didn’t have the benefit of “hindsight” to lean on.
Current Events: What Do Bonds Have Going For Them Now?
JP Morgan Guide to the Markets
All that being said, bonds are in a unique position right now (although similar to where we stood 5 years ago before rates started to rise). So what do bonds have going for them other than just how they behave as part of your overall return experience? There are a few tailwinds out there for bonds. For U.S.-based bonds, while interest rates are low in the U.S., they are still better than other countries with the exception of emerging markets and below investment grade issues. This steadily attracts buyers of our debt supporting prices even at these low-interest rates.
Another point is that we are still in the midst of a pandemic, there could continue to be unanticipated economic impacts that affect markets unexpectedly. The economy is pretty vulnerable right now and when we are vulnerable an unexpected shock (black swan event) could have a larger than expected impact on markets if it were to occur. Remember these are events no one could see coming (like the pandemic itself!). Right now it is a far easier decision to sell stock positions and rebalance into bonds while calmer markets are prevailing than in the midst of a downturn. These markets are pricing everything to perfection, rates staying low, Federal reserve continuing with their bond-buying strategies, vaccine dosages being deployed without a hiccup, no more widespread shutdowns, another government stimulus package, etc. Things don’t always go to plan so adding to bonds helps to insulate you against events that are out of our control.
Another caveat to this is the lower interest rates are, the fewer bonds tend to correlate with stocks. Meaning when rates are lower the assistance they provide during equity market downturns should be improved.
The chart below provides the historical basis for this view. It shows for each month since 1926 the stock-bond correlation over the subsequent 120 months (orange line). The chart also plots for each month where the 10-year Treasury yield stood (blue line). Notice that the two data series tend to rise and fall in unison, with higher Treasury yields associated with higher stock-bond correlations over the subsequent decade. It also shows that while the 10-year treasury rate stays below 4% their performance remains uncorrelated or negatively correlated which is exactly what we are hoping for in the event of equity market volatility.
What If The Markets’ Worst Fears Are Realized And Rates Increase Causing Bonds To Lose Value?
A bad year of performance for bonds is far different than for equities. This decade has had some tough years for bond positions. The Bloomberg Barclays US Aggregate bond index has experienced a negative performance calendar year in 2013 (-1.98%) and two years where returns were essentially flat (2015 up .48% and 2018 up .1%). While it is hard to predict the path of interest rates over the coming year diversification within your bond portfolio will be important. For example, shortening the duration of the bond portion of your portfolio may help alleviate some of the risks of interest rates rising (remember when interest rates rise bond prices tend to fall).
I hope this helps your understanding as to why we are interested in still owning bonds as a portion of your investment portfolio! Please don’t hesitate to reach out with any questions you may have!
Angela Palacios, CFP®, AIF® is a Partner and Director of Investments at Center for Financial Planning, Inc.® She chairs The Center Investment Committee and pens a quarterly Investment Commentary.
This material is being provided for information purposes only. Past performance doesn't guarantee future results. Investing involves risk regardless of the strategy selected, including diversification and asset allocation. The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The S&P 500 is an unmanaged index of 500 widely held stocks that's generally considered representative of the U.S. stock market. You cannot invest directly in any index. 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. There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices rise.