It is easy to ignore bonds. Bonds don’t generate the same flashy headlines as stocks, (“DOW 21,000!!!”). Bonds also don’t swoon or shoot up the way stocks do. When was the last time you heard investors talk in near panic terms about a bond market “crash?” or coo about “new highs?” In spite of their low profile, bonds are extremely important for any diversified portfolio. It is time to revisit them.
Cycles in the bond market are long. The current bond bull market began in September 1981. During the last 35 years, investors have generally enjoyed positive returns on their bond holdings. Bonds are debt and pay a coupon to those who purchase the debt. In addition, bond prices fluctuate with interest rate changes. As interest rates fall (as they have over the past thirty five years), bond prices usually rise, creating a positive return on top of any interest rate payment. In other words, during a bull market bonds are favored for their potential income and modest return on investment.
All of this good news about bonds could be about to change.
On March 15th of this year the Federal Reserve raised interest rates for the third time since the financial crisis, and the first time in successive quarters. The Fed seem signalled increasing confidence in global growth and satisfaction with its interim targets for employment and inflation. At issue is whether this move could herald the much awaited pivot to the next bond bear market.
In bond bear markets, interest rates rise causing prices to fall. Your existing bond portfolio is worth less because someone else can buy a new bond with a higher interest payment than the ones your bonds offers. When your bonds come due, however, you can roll the matured bonds into new ones with higher coupons. Yet overall the returns on bonds during a bond bear are less than during a bond bull, and the returns can be negative more frequently. That is why it is important to review your bond holdings at this time.
Here are three factors to consider when evaluating your bond holdings. (For this blog we are focused on bond funds.)
- Diversification Just as with stocks, your bond holdings need to be diversified. There are many different types of bonds (US Treasuries, agency bonds, mortgage backed securities, investment grade corporate bonds, high yield bonds, floating rate bonds, inflation protected securities, municipal bonds, asset backed securities, emerging market bonds etc.) Bonds also come with different durations and different countries of origin. Since not every bond type responds to changes in interest rates in the same way, it is best to hold a variety of types of bonds to balance out interest rate risk. That means, at a minimum, focusing on multi-sector bond funds as well as a traditional intermediate term US bond fund.
- Unconstrained bonds: It may finally be the time for unconstrained bond funds to shine. These are funds that can bet against rising interest rates and are designed to help you weather bond bear markets. Unconstrained bond funds ran into a bit of trouble the last few years when the bond bear market didn’t materialize. However, now that we may be closer to the beginning of the bond bear, it might be worth holding a small portion of your portfolio in these unconventional bonds to help reduce risk.
- Active vs Passive: The recent debate between active and passive management has revolved around stocks, in particular US large cap stock funds. The argument is that more expensive actively managed stock funds generally underperform their passive indexed benchmarks. We agree with that. However, we do not feel the same equation applies to bond funds. Most passive indexes are weighted by market capitalization. In bond indices that means weighting by the size of debt. We would argue that the biggest borrower isn’t necessarily the healthiest one. Given the number of choices bond investing offers we gravitate towards actively managed bond funds. Select experienced managers with known track records and be mindful of the underlying costs.
One final comment: On a very broad basis, investors can divide themselves into two groups – those seeking the best performance and those desiring the least downside risk. Bonds belong, especially, in portfolios of those who desire to control volatility, as bonds can provide ballast in both bond bull markets and bond bear markets. While bond performance going forward may lag returns of the last thirty-five years, bonds and bond funds can continue to be important contributors to many portfolios.
Betsey A. Purinton, CFP® is Managing Partner and Chief Investment Officer at StrategicPoint Investment Advisors in Providence and East Greenwich. You can e-mail her at firstname.lastname@example.org.
The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Betsey’s opinions and comments expressed on this site are her own and may not accurately reflect those of the firm. Third party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference.