One of the staple investment beliefs has historically been that “bonds are for protection and stocks are for growth”. While the evidence has generally backed this up, it is important that we balance what worked before with the current and future investment environment. As every investment compliance attorney has said, “past performance is no guarantee of future results”.
When it comes to investing, there are two main risks that most people think about:
- Loss of Principal (Negative Returns)
- Loss of Purchasing Power (Inflation)
Historically, most investors have viewed bonds as the best protection against losing money in their investment portfolio while stocks were viewed as providing long-term growth to keep up with inflation. This approach has done
well, with a portfolio 60% stocks and 40% bonds earning over 10% annual returns the last 50 years. HOWEVER, investors today are not investing for the LAST 50 years, but the NEXT 20-50 years. The question for investors is what will work going forward.
I have heard of long-term “wise” advisors that stick with the philosophy that bonds are a very safe part of the portfolio, regardless of market conditions. The problem with this approach is that just about every current financial advisor has ONLY worked with clients during a falling interest rate environment. The 10-year US Treasury Rate peaked at 15.6% in October 1981, over 40 years ago. Over the last 50 years (remember, when the 60/40 portfolio returned 10.7% on average), interest rates averaged 6.2%. Today, the US 10-year Treasury Rate is only 2.8%. This creates a different investment environment than any that current advisors and investors have lived through, and, arguably, investment strategy needs to adjust accordingly.
How do bond investments make money?
Returns for bonds are calculated like other investments: Income + Change in Price. The income component is easy to estimate, as it is the current interest rates. However, future change in price is harder to predict. The price of bonds moves inverse of interest rates. That is to say, when interest rates go up, price of bonds fall, and vice versa. We do not believe that anyone can accurately and consistently predict the movement of interest rates. Therefore, it is best to defer to the overall market, which means we do not believe in expecting a change in price for bonds. The best way to approximate the future returns of bonds is current interest rates, now at 2.8%.
While expected returns are lower, the volatility for bonds is also higher. It is not a coincidence that 2022 has so far been the worst returns for bonds historically, as we started the year at one of the lowest rates ever, 1.52%. Only 2021 started the year at lower US 10-year interest rates, 0.93%.
Since 1981, the Bloomberg Barclay’s US Aggregate Index has only ended a year with negative returns 4 times. This makes sense as interest rates have generally been falling and starting rates have been higher.
But now, with interest rates very low, small moves in interest rates dwarf the interest received. Without “nerding-out” too much with bond math, let’s just think through a general example.
Imagine two scenarios. First, that you have a bond earning the market rate in March 1987 of 7.51% and then interest rates rise 1% to 8.51%. This is a change in interest rate of approx. 13%.
In the second scenario, interest rates rise the same 1%, but instead of March 1987, it’s May 2020 and rates are 0.65%. A 1% rate rise is an increase of 153% from the starting point. This 1% move in rates matters significantly more when rates are low than when rates are high.
This means that small moves in interest rates cause large moves in the price for bonds. Add in the fact that almost everyone would agree that bonds have more room to go up than they do to drop, and you have a recipe for higher potential of losses in your bond portfolio.
What do you do?
So, if bonds have higher volatility and lower returns, what should you do with your portfolio? You have a few options that you should consider:
- Lower duration of your bonds – Duration is a term that describes the interest rate sensitivity of bonds. Lowering duration can lead to lower volatility. When the “yield curve” is very flat, meaning short-term rates are similar to longer-term rates, investors are not highly compensated for purchasing longer-term bonds. Right now, short term bonds have similar yields to longer term bonds. If returns are not going to be higher by increasing the term, you should look to shorten the duration of bonds to reduce the risk of losing money as interest rates rise.
- Rebalance your portfolio – Over the last few years, we have consistently reduced our clients’ exposure to bonds as interest rates fell (and prices rose). This fits into our overall rebalancing philosophy, which is to use cash, dividends, and interest to purchase assets that are relatively below their target allocation and to sell securities that have become overweight in the portfolio. As interest rates bottomed out in 2020, we steered away from reinvesting into bonds at these low rates and invested in other areas of the market. The best time to reinvest and reduce bond exposure was the last few years, but that doesn’t mean that you should just stick with an overweighting to bonds today.
- Build an Individual Bond Ladder – for many of our clients, we build out individual bond ladders (generally with maturities from 2 to 12 years). This means that we choose bonds that have specific maturity dates spread over a decade or more. Then, instead of worrying about the change in price from interest rate movements, we purchase bonds with fixed rates and hold them until they mature. As long as the bond does not default, we have all the numbers we need to calculate positive returns: 1) The price paid for the bond, 2) the interest received every 6 months and 3) the amount received in cash upon maturity. This approach can do very well during rising interest rate environments, as long as investors are able to hold these bonds until they mature.
- Prepare for Lower Returns – Lastly, investors should be prepared for lower investment returns looking ahead compared to the last several decades. Unfortunately, the only way to achieve the old 60/40-type returns of 10.7% is likely to involve taking significantly higher risks, which is not where most investors want to be.
Lower interest rates for bonds should be a trigger to reduce bond exposure in investor portfolios, both because of lower expected returns and the higher potential for losses in the “safe” part of the portfolio. Add in inflation and it is likely that bonds will not provide anywhere near the same level of portfolio protection and returns as they have the last 40-50 years. There are still options available for investors to make intentional decisions to allocate their portfolio across all asset classes, but it involves a realistic look at expectations ahead.