Aaron Stolpen, BridgeTower Media Newswires
With Treasury yields firmly hovering near 2020’s all-time lows, the looming threat of inflation, and a Federal Reserve that recently began its long march toward policy normalization, investors may be wondering whether investing in bonds is still a wise choice.
While the modest yields offered these days are unlikely to inspire the levels of enthusiasm they once did, bonds remain an important piece of a well-constructed investment portfolio.
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Any port in a storm
Of the many benefits bonds provide in an investment portfolio, perhaps the most crucial is their stability.
After a year and a half in which nearly ever asset’s performance chart can be described as “up and to the right,” it can be easy to forget that stocks do suffer losses from time to time.
The occasional debt ceiling showdown notwithstanding, government bonds are effectively free from default risk. While changes in interest rates may cause temporary losses on the bonds in your portfolio, these losses are vastly less severe than in equities or other risk assets. In fact, since 1927, a portfolio of 10-year Treasury bonds has had an annual total return of -5% or worse only five times:
In 1969, 1994, 1999, 2009, and 2013. By contrast, there have been 80 times where the S&P 500 index of stocks has dropped by that much or more in a single day.
Beyond simply making it tougher for some of us to sleep at night, the higher volatility that comes with an over-allocation to risky assets can create a major hurdle to the long-term success of an investment portfolio. Because returns do not compound linearly losses will hurt more than gains will help.
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The only free lunch
Beyond simply exhibiting low historical volatility, fixed income such as bonds can reduce the risk profile of a portfolio through the benefits of diversification.
Famously called “the only free lunch in investing,” diversification is a vital feature of a well-managed investment portfolio. Diversification is the principle that by combining investment assets not impacted by one another or investment assets that tend to react in opposite ways, the volatility of the resulting portfolio will be lower than the average risk of the portfolio parts.
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Don’t fear the reaper
One objection we sometimes hear about keeping bonds in a portfolio is that the returns we have experienced have been the result of a 40-year decline in interest rates. The logic goes that this lowering interest trend is all-but-certain to reverse itself now that we have been pushed against the very lowest rates can go. However, neither economic theory nor data support this idea of returns resulting from declining interest rates. Interest change rates tend to be a wash throughout the life of a bond.
There are some who believe they should avoid bonds for the time being, thinking that as interest rates begin to rise, the value of the bonds will decrease. But there is no reason to be overly concerned. Rather than causing crippling permanent losses to you as a bond investor, a period of rising interest rates would at worst delay some of the returns an investor may earn over time.
By waiting to invest until after rates rise, however; investors are hoping they can predict the timing and path of future interest rates. Not only that, but also timing it so well they would make up any bond yields lost in the interim. The likelihood of being successful with that timing is slim and extremely unlikely, and not worth losing out on the bond earnings over the timing you may be avoiding bonds.
Bonds help bring stability, support diversification and yield over time. It’s natural in such a low-interest rate environment to question the value of bonds in your investment portfolio, but concern about interest rates should not outweigh the importance of that stability and diversification in your investment portfolio.
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Aaron Stolpen, CFA, Esq., is a senior portfolio manager at Domani Wealth.
