As bonds have struggled, producing losses in client accounts over the past couple of years, we have had more clients ask the question: Should bonds still have a role in the portfolio?
Traditionally, the answer has been that bonds provide diversification and income. They zig when stocks zag, providing income for spending needs. In finance terms, bonds have “low correlation” levels to stocks, and adding them to a portfolio would help to reduce the overall portfolio risk. However, over the last two years, as the Fed has worked to aggressively raise rates, this correlation has increased. What we saw in 2022 was the bonds fell right along with (and nearly as much as) stocks.
Compound that with the current state of interest rates. One of the most basic investing truisms is you should pursue investments offering a higher interest rate over investments with lower interest rates for the same level of risk. It just makes sense — of course you would want to earn more interest. Another concept involves how soon you get your investment back (liquidity). All else equal, you would want to make shorter-term loans where you would get your principal back sooner rather than later. The only way that you would be willing to lend your money for longer is if you received more interest to do so.
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However, in today’s interest rate environment, investors are earning more on short-term bonds than long-term bonds, as you can see in the chart below. And investors are earning even more on federally insured certificates of deposit (CDs). As the chart below shows, one-year CDs currently pay 5.8% compared to only 4.8% for a 10-year Treasury bond.
(Image credit: Stacy Francis)
Given all this, it seems like a no-brainer to invest in the short-term options and receive the higher interest rates and better liquidity that come with them. If bonds aren’t fully dead, why not at least eliminate the default risk of lending to companies and invest only in short-term CDs and Treasury securities? At first glance, this strategy seems brilliant and, frankly, “too good to be true.” And, of course, that is the case. This is where having a long-term investment approach comes in.
What happens a year from now?
To illustrate the point, let’s think about the longer term. What happens 12 months from now when the one-year CD matures? At that point, investors must look to reinvest the proceeds they receive. Most market pundits expect that the previously mentioned aggressive increase in interest rates by the Fed will at minimum slow the economy dramatically, if not push the U.S. economy into a recession.
If that happens, overall interest rates will fall as the Fed looks to reduce interest rates to stimulate economic growth. That makes it highly likely that investors won’t earn the current 5.8% rate if they reinvest their CDs next year.
For those who invested in a two-year CD and accepted the lower 5.1% rate, they don’t have this concern, known as reinvestment risk, for an extra year. The longer term of the current investment, the further investors can push out the concern over reinvestment risk.
When long-term bond prices will rise
Additionally, just as longer-term bonds fell when interest rates went up, the prices of long-term bonds will rise when interest rates go down. That is because investors looking to reinvest the proceeds from their maturing CDs are willing to pay extra for long-term higher rates, which are no longer available in the marketplace.
The result is that bonds in general, and long-term bonds in particular, tend to do very well after the Fed stops raising rates (the Fed left rates unchanged at its latest meeting, in December). A study by Capital Group that looked at how bonds performed after past Fed rate-hiking cycles provides room for optimism — that maintaining a bond position in your portfolio may once again provide positive returns, income and diversification benefits.
According to that study, bonds have provided returns of over 10% in the 12 months following the end of the rate-hiking cycle and have compounded at 7.1% over the next five years, well above the long-term average of 4.8%.
Bonds still play a critical role in portfolios
We still believe that bonds play a critical role in client portfolios and that beginning to shift to longer-term bonds could benefit investors over the long-term, given today’s higher interest rates. It is easy to take a short one- to two-year timeframe and wonder if the world has changed, but successful investing requires a long-term focus of seven to 10 years, incorporating full market cycles.
When you’re working with a financial adviser, they will be there to help you keep that focus and to best position your portfolio to generate the long-term returns necessary to achieve your financial plan. Bonds continue to play an important role in that goal.
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Disclaimer
This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
Traditionally, the answer has been that bonds provide diversification and income. They zig when stocks zag, providing income for spending needs. In finance terms, bonds have “low correlation” levels to stocks, and adding them to a portfolio would help to reduce the overall portfolio risk.
In addition to providing a predictable source of income, bonds can also help balance risk and protect a portfolio when stock markets are moving downwards. Ultimately, holding bonds in a portfolio can help with diversification.
There are many adages to help you determine how to allocate stocks and bonds in your portfolio. One says that the percentage of stocks in your portfolio should equal 100 minus your age. So, if you're 30, such a portfolio would contain 70% stocks and 30% bonds (or other safe investments).
Many investors include bonds in their portfolio as a source of diversification to help reduce volatility and overall portfolio risk. The chart below shows the historical volatility of different asset classes – including bonds and stocks – over recent decades.
Bottom Line. Moving 401(k) assets into bonds could make sense if you're closer to retirement age or you're generally a more conservative investor overall. However, doing so could potentially cost you growth in your portfolio over time.
Longer-term bond yields remain far more compelling today than they have been in years.” Merz says for conservative investors, “It's possible to generate reasonably attractive returns in a mix of bonds without extending their risk budget.”
As for fixed income, we expect a strong bounce-back year to play out over the course of 2024. When bond yields are high, the income earned is often enough to offset most price fluctuations. In fact, for the 10-year Treasury to deliver a negative return in 2024, the yield would have to rise to 5.3 percent.
The 70/30 rule is a guideline for managing money that says you should invest 70% of your money and save 30%. This rule is also known as the Warren Buffett Rule of Budgeting, and it's a good way to keep your finances in order.
The common rule of asset allocation by age is that you should hold a percentage of stocks that is equal to 100 minus your age. So if you're 40, you should hold 60% of your portfolio in stocks. Since life expectancy is growing, changing that rule to 110 minus your age or 120 minus your age may be more appropriate.
“Yields are still attractive.” What's key for investors to remember is that “lower” is all relative. Bond market strategists and fund managers generally agree that yields are still attractive, especially relative to inflation, and will likely stay higher than before the pandemic.
Bond laddering is one of the most common forms of passive bond investing. The investor divides the portfolio into equal parts, then buys bonds that mature on different dates. Each maturity date represents a "rung" on the ladder, which is the investor's entire time horizon.
With more than a decade or two of working years left until retirement, it's important to maintain the growth potential of your portfolio through an appropriate allocation to stocks. In your 50s, you may want to consider adding a meaningful allocation to bonds.
Stock investors also often turn to high-yield corporate bonds to fill out their portfolios as well. This is because such bonds are less vulnerable to fluctuations in interest rates, so they diversify, reduce the overall risk, and increase the stability of such high-yield investment portfolios.
If a retiree is going to need the money within a few years, a Treasury bond might not be the best choice considering its long maturity date. Although a Treasury bond can be sold before its maturity, the investor may take a gain or loss, depending on the bond's price in the secondary market at the time of the sale.
Bonds, especially government and high-grade corporate bonds, are often less volatile than stocks. Therefore, an investment in bonds could provide a smoother and more predictable path to your financial goals, particularly if you're nearing retirement and have a lower risk tolerance.
Key central bank rates and bond yields remain high globally and are likely to remain elevated well into 2024 before retreating. Further, the chance of higher policy rates from here is slim; the potential for rates to decline is much higher.
As you can see, each type of investment has its own potential rewards and risks. Stocks offer an opportunity for higher long-term returns compared with bonds but come with greater risk. Bonds are generally more stable than stocks but have provided lower long-term returns.
Bonds, especially government and high-grade corporate bonds, are often less volatile than stocks. Therefore, an investment in bonds could provide a smoother and more predictable path to your financial goals, particularly if you're nearing retirement and have a lower risk tolerance.
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