What About Bonds?

The good news: Since November 7th, the S&P 500 is up almost 6% and small cap stocks are up twice that. The not-so-good news: The stock surge since Election Day has hidden the bond market's recent slump.

The slump began over the summer but accelerated following the election. Since then, the yield on the 10-year Treasury bond, a key benchmark, has risen almost 35%, from about 1.7% to 2.3% (rising yields mean falling prices). In terms of actual investment impact, the broad bond market index is down about 2.5% since November 7th. Short-term bonds are down about 1.5%, but long-term bonds, which feel the impact of rate changes more dramatically, are down over 5%. That's a big move in the bond world and more may be coming.

While most people have an intuitive understanding of stocks (owning stock is owning a small piece of a real-world business), the bond market can be hard to understand. Bonds are often thought of as boring, an afterthought, or even intimidating. But bonds are more important than you might realize. From an economic perspective, the bond market impacts all kinds of interest rates, shows expectations for inflation, and can alter the course of the stock market. From a personal perspective, however, bonds, if handled correctly, can be an anchor in your portfolio. But they are subject to interest rate changes, and we're in a time of transition.

The Federal Reserve Open Market Committee meets in a couple of weeks and the bond market is assuming a 95% chance the Fed will raise rates again. One of the many interesting aspects of the bond market is that the Fed doesn't have to raise rates for them to go up anyway. Should the Fed end up raising rates this month, we could end up seeing a near-doubling of the 10-yr yield from where it was a few short months ago. This would be a sizeable, if not wholly unexpected, shift in rates.

It's natural to ask some fundamental questions about bonds at a time like this. Why are bonds important to own? What are the risks associated with bonds? What are the benefits? Why would we want to own bonds if they decline in value as interest rates rise? And aren't interest rates expected to rise continually?

I just received this article from Vanguard. While it's written for the advisor, the information is useful and gets to the fundamental questions.

Click below to continue reading and view a chart comparing risks of stocks versus bonds...

Yes, the rate rise has spawned many headlines. But whether rates continue to increase, no one knows.
 Rather than help clients by calculating outcomes, help them by offering perspective. While the suddenness of the climb has unsettled many, higher rates are good for many reasons and should not induce panic.

For those wanting to sell out of bonds, ask if they would prefer the reality of underperforming bonds to a world in which all asset classes in their portfolios moved down at the same time and by a similar magnitude. Ask if they're also ready to sell their stock positions, which are riskier than any bond position.

Remind skittish clients that investing success is defined by the long term and can require discipline and diversification.

Perspective on rising rates in general


It's the change in expectations that moves rates and bond values. Higher rates (with a modest increase in inflation) mean a healthy economy and higher-income opportunities, both of which are good for long-term investors, and have been the goals of the Federal Reserve and policymakers for some time.

There's no guarantee rates will continue to rise in the short term. Unexpected fiscal or monetary policy events could result in downward pressure on rates. Rates don't have to rise just because they're low, and they don't have to keep rising just because they have recently.

As a rule of thumb, investors with a time horizon longer than the duration of their bond holdings will be better off in the long term with a rise in rates today.

What has driven rates up this time


A change in political power can heighten uncertainty, which markets don't like. The bond market sell-off is an indication that investors are continuing to digest unknowns, which include projections that U.S. economic growth could see a short-term boost under President-elect Donald Trump's agenda. That said, many factors affect the prospects for growth, well beyond policy proposals.

Markets are also responding to increasing expectations that the Fed will raise rates in December. However, the Fed has indicated that the pace of future increases will be gradual, which is likely to translate into lower bond market volatility and a more benign environment, rather than one in which rates rise sharply.

Role of bonds in a portfolio


Successful portfolio construction is not just about returns. It is also about diversification or downside protection. The primary source of risk in portfolios is stocks, not bonds.

While Treasuries have seen the biggest price declines in the recent surge, high-quality bonds have been great diversifiers against the larger losses of stock holdings. This has largely been the case throughout the markets' histories. But we saw it recently in August 2015, January 2016, and June 2016.

The total-return experience over time is likely to be less volatile if bond allocations are maintained. When bonds declined in the past, the equity portion of a balanced portfolio often more than offset the decline.

Diversifying bond exposure globally (and hedging the currency risk) is one option to mitigate the short-term risks of a rise in domestic interest rates without altering strategic asset allocation.

Risk of loss (bonds versus stocks)


The risk of loss for bonds is very different from the risk of loss for stocks in the potential magnitude. We've seen on average negative returns in bonds once every six years, versus negative returns in stocks once every four years.

A bad result for a diversified bond portfolio is usually better than a bad result for stocks. The stock market's worst 12-month return was a decline of 67.6% (S&P 90 Index, ended June 30, 1932). Bonds have had a much better downside profile, with the worst 12-month return a decline of 13.9% (Lehman Brothers U.S. Long Credit AA Index, ended September 30, 1974).

Impact of rising rates on portfolios


Shortening maturities may help protect principal in the short run but could lower income over the long run. Bond funds with longer durations may take longer to recover principal, but, historically, the recovery has not been much more than those for shorter-duration funds.

Duration tilts are difficult. The long-term natural level of interest rates is uncertain. Duration bets must be placed almost perfectly on the yield curve to pay off.

Have questions? Ask me. I can help.