Do We Still Need Bonds In Our Portfolio (Part 1)
With the prospect of rising rates in the US, and relatively weak run for fixed income in recent weeks, some now question the role of fixed income in a portfolio. Here is 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 does not apply to the whole universe of bonds.
These are the bonds that will still do well in a rising interest rate environment:
- Bonds with maturity shorter than 7 years.
- Bonds with coupon reset feature.
- Floater bonds.
- High yield bonds that generate yield of more than 6%. (However high yield bonds generally come with greater issuer risk).
Expectations that Trump, along with a Republican-led Congress, would make good on pledges to spend $550 billion on infrastructure improvement to stoke economic growth sent inflation expectations to the highest since 2015. This led to more aggressive interest rate hike expectation in 2017.
However forecasts have generally been too early in predicting further rate increase over the past several years. Investors need to question how much extra government spending president-elect Donald Trump will be able to implement once his administration takes office. Let us not forgetting that Fed Chairwoman Janet Yellen has constantly said rate hike will be gradual.
One of the challenges in portfolio construction is that there are many sources of return (from equities investing, forex and option trading), but they often come at a cost of downside risk. This creates a role for bonds.
Bonds don’t always rise strongly in 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 investors stay the course and help with 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 large cap investment grade rating issuer 10 year bond for the entire 10 years, and there is no default, 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 bonds are particularly valuable for those with shorter time horizons. Certainly bonds have a lower return in most historical periods, but investors are much less likely to endure a bad short term outcome with bonds than with equities.
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.
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 does not apply to the whole universe of bonds.
These are the bonds that will still do well in a rising interest rate environment:
- Bonds with maturity shorter than 7 years.
- Bonds with coupon reset feature.
- Floater bonds.
- High yield bonds that generate yield of more than 6%. (However high yield bonds generally come with greater issuer risk).
Expectations that Trump, along with a Republican-led Congress, would make good on pledges to spend $550 billion on infrastructure improvement to stoke economic growth sent inflation expectations to the highest since 2015. This led to more aggressive interest rate hike expectation in 2017.
However forecasts have generally been too early in predicting further rate increase over the past several years. Investors need to question how much extra government spending president-elect Donald Trump will be able to implement once his administration takes office. Let us not forgetting that Fed Chairwoman Janet Yellen has constantly said rate hike will be gradual.
One of the challenges in portfolio construction is that there are many sources of return (from equities investing, forex and option trading), but they often come at a cost of downside risk. This creates a role for bonds.
Bonds don’t always rise strongly in 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 investors stay the course and help with 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 large cap investment grade rating issuer 10 year bond for the entire 10 years, and there is no default, 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 bonds are particularly valuable for those with shorter time horizons. Certainly bonds have a lower return in most historical periods, but investors are much less likely to endure a bad short term outcome with bonds than with equities.
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.
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