Bonds are under fire.
This favored investment of old-money matrons and conservative investors is suddenly controversial with many investors reconsidering bonds.
Why? Because interest rates and bond prices move in a seesaw pattern. When interest rates go up, as they have since mid-2016, bond prices fall. This reality has even the most risk-averse investors wondering whether bonds still have a place in their portfolio.
What to know about bonds if/when reconsidering your investment strategy
We really don’t know whether interest rates will continue to rise. And even if they do, not all bonds will react in the same way to that increase. What’s more, compared to stocks, commodities, etc., bonds provide significant price stability even when interest rates are on the move.
More on all of this in a moment. But first, here’s a quick overview of bonds…
Bonds are simply IOUs issued by a company or government. When you buy a 5-year bond for $10,000, the seller is using the $10,000 for that specific term, while at the same time paying you an annual interest rate. At the end of the term, known as the bond’s maturity, you get your $10,000 back. Over the whole term you’ve collected $500/year, (5% on $10,000), and had your original principal returned.
Of course, there is some risk associated with bonds. If a bond’s issuer goes broke, its bonds will default, becoming worthless. Default rates vary by the type of bond. U.S. government bonds are the gold standard of credit. The U.S. has not defaulted on a bond since the late 1700s. This makes U.S. debt “risk-free” in the eyes of global investors.
Corporate bonds are also generally pretty low risk, with the average default rate of less than one half of 1% over the past 50 years. High-yield, or junk bonds are riskier, with an average 20-year default rate of 3.9%.
If/when will rates actually rise?
At the beginning of 2014, most economists thought we’d see a rise in interest rates as measured by the U.S. 10-Year Treasury Bond. Rates actually fell to about 2% that year.
Similarly misguided predictions have been widespread since 2010. What if you had sat out of the bond market for the past 7 years thinking rates would rise? In cash, you would have earned about 0.7%. In that same timeframe, the U.S. core aggregate bond index ETF (AGG) had a total return of 27% or 3.5% per year.
Don’t get me wrong. I’m not suggesting rates won’t go up from their current 2.5% range. But predicting interest rate trends is every bit as difficult as predicting the exact peaks and vales of the stock market.
Not all bonds are created equal
Rising interest rates can have hugely different effects on the various bond categories. For instance, very long-term bonds (30-year U.S. Treasuries) will fall 17.7% when interest rates rise 1%, while floating rate bonds stay almost flat (see chart below).
Keep in mind that this doesn’t account for the annual income you receive from a bond. So in the case of floating rate bonds, convertible bonds and U.S. high-yield bonds, the average income paid will often generate a positive total return, despite the headwind of rising rates.
Bonds provide price stability that few other asset classes can offer. That’s why those old bluebloods love them so much.
In a bad month stocks can drop 17%. A terrible month for bonds might result in a 2.4% dip. That’s exactly what happened in November 2016, the worst month for bonds in 12 years.
Well-chosen bonds can help dampen wild portfolio swings, regardless of the interest rate environment. This is really important, because investor emotion is a leading cause of lost portfolio value. Too many of us fall prey to fear and imprudently sell assets when our portfolios head into a downswing.
Going back to 1950, the best year for stocks saw a 47% gain, while the worst was down 39%. A portfolio made up of 50% stocks and 50% bonds registered only a 33% gain as its best year, but in its worst was only down 15%. How’s that for even-keeled?
Finally, remember that the main reason to own bonds is for the interest income they generate. Government bonds currently yield between half a percent and 3%, while corporate bonds pay between 2% and 4%, and high-yield bonds offer 4-6% per annum. This may not sound like a lot, but taken over a decade those little numbers can add up to significant returns.
So, with interest rates rising, do bonds still have a role to play in your portfolio? Absolutely. Even if bond yields fall in the coming years, this core asset will continue to trickle income into your portfolio while providing a buffer against the volatility of the stock market.
Keep calm and continue clipping those bond coupons!