Why you should make room for bonds

 Joseph G. Mowrer III, The Daily Record Newswire

We’ve all been hearing that we are nearing the end of the 30-year bull market in bonds. The yield on the 10-year Treasury Bond has declined steadily from over 15 percent in 1981 to its current level of below 3 percent, where it has remained for some time.

Bond investors have been scared of owning bonds or bond funds in a likely rising rate environment for fear of low returns and the possibility of loss of principal. For this reason, they may be inclined to eschew bonds in favor of dividend paying stocks, complex derivative securities or other riskier alternatives.

While these investors may believe they are avoiding one risk (rising interest rates), they may really be significantly increasing the risk and volatility of their portfolio, and neglecting the principle reasons they put bonds in their portfolio in the first place. Namely, bonds generate: (1) predictable income, (2) provide diversification to equities, and (3) preserve capital during periods of economic weakness.

Looking at the first factor, even in a rising rate environment, bonds generate a steady and predictable stream of income. While a rise in interest rates in the near term can create temporary losses in principal, bond investors should view their portfolio returns in terms of years or even decades. Indeed, bond investors, who re-invest their income at prevailing market rates, will offset most of the impact that rising rates can have on a bond portfolio’s principal.

According to a study by John Bogle of Vanguard Group going back to 1926, the current yield of a 10-year Treasury Bond explains 92 percent of the annualized return going forward (assuming the bond is held to maturity and income is re-invested at market rates). While the current 2.8 percent yield on a 10-year Treasury bond is nothing to write home about, it is predictable and provides assurance of a positive return over the next decade (ignoring inflation and default risk). This type of predictable return cannot be matched with any other investment.

Bonds are also the only true diversifier to an equity portfolio and should be viewed as a stable building block to any portfolio. While equities continue to reach new highs, it’s easy to forget how fast they can turn the other way. It was not long ago we watched the S&P 500 index plummet by 57 percent in fewer than 17 months, while during this same time, a typical 10-year Treasury Bond fund returned around 20 percent.

High quality bonds, such as U.S. Treasuries, also tend to react positively to any news of economic shock or political unrest. For the most part, this protects investors against bad news that trickles into the economy.

Since interest rates are no more predictable than stock prices, bond investors should not try to time the bond market. Instead, they should choose a suitable allocation to bonds based on their risk tolerance (age as a percentage is a good guideline), and use high quality diversified funds.

While interest rates are low by historical standards, there is no reason to assume they cannot stay where they are for a long time, or even go lower. For this reason, investors who avoid bonds altogether are taking on a risk of missed opportunity.

Despite low yields and relatively low expected go forward returns, bonds still provide investors with the same predictable income, diversification and a hedge against economic shocks that they always have.  Over the long haul, there is no substitute containing these attributes.


Joseph G. Mowrer III is a senior tax-sensitive fixed income analyst for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.