Why Hold Bonds?

The April 17th Wall Street Journal headline reads: “Bond Rout Promises More Pain for Investors: Rising yields are largely a good sign for the economy, but bondholders are paying for robust growth. Some investors suspect the Fed’s rate message hasn’t sunk in.” News like this can make you wonder why anyone would invest in bonds these days. If interest rates are going to continue to rise, does investing in bonds make any sense?

6 Reasons to Invest in Bonds

While we want to remind the reader that it is important to maintain a diversified portfolio that is developed around your short-term cash needs and long-term investment objectives, here are some reasons to continue to invest in bonds:

1. Prices today reflect interest rate expectations for tomorrow.

For bond prices to go down further, interest rate hikes would have to be greater than what is expected in the market today. There are different views on this, and current markets suggest a 75% chance of 0.50% rate hike in May and 65% chance of another 0.50% in June. Some economists argue that rates will not go that high because current supply chain issues and global conflict are slowing economic growth. Others argue that rates will go higher as inflation continues to expand, and the Fed must move more aggressively.

Both parties cannot be right, but we know markets today already reflect the pain of the past increases as well as the current expectation of future increases.

2. Bonds still do provide some downside protection relative to equities.

While the bond prices can go down and have gone down just over -10.6% over the last year (Bloomberg Global Aggregate Index), this decline - which is one of the worst on record for bonds - is much less than the declines that equity markets have historically experienced during corrections. In fact, an equity market decline of greater than -10% has occurred at rate of 0.5/year since 1946 (38 times).

3. US Treasuries have tended to tick up in value during times of equity market distress, and municipal bonds have provided some historical protection as well.

Depending on the bond, some have provided more protection in times of crisis than others. For example, US Treasuries have tended to tick up in value during times of equity market distress, and municipal bonds have provided some historical protection as well. Whereas higher credit risk bonds, e.g. corporate bonds and junk bonds, often have valuation declines in times of market distress. “Flight to safety” has favored US treasuries and municipal bonds to some extent.

4. Cash loses in inflation.

Why not just move to cash? Cash loses in inflation. At a current 8.5% year-over-year inflation, you may have the same $10,000 in your bank account in one year, but its value will have degraded a fair bit! The market continues to expect higher inflation rates than what has been witnessed in the prior two decades.

What is the risk of bond prices and inflation? As a general rule, for every 1% increase or decrease in interest rates, a bond's price will change approximately 1% in the opposite direction for every year of duration. Duration is a measure of a bond’s sensitivity to interest rates and is driven by the maturity of a bond as well as the coupon payment. For example, if a bond has a duration of 5.7 years (the duration of the Vanguard US Treasury Intermediate Term ETF, VGIT), and if interest rates increase by +1% unexpectedly, the bond's price will decline by approximately -5.7%.

So, there is downside risk if interest rates are hiked significantly more than what the market is forecasting. Of course, shorter duration bonds reduce this risk more. (See next point)

5. Shorter-duration bonds have less price risk in rising interest rate markets.

You can see the lower price risk of shorter-duration bonds over the last year. Long-term treasuries are down much more than shorter term bonds. The Bloomberg US Treasury 20+ Year Index is down -11.1% over the last 12 months vs. the Bloomberg US Treasury 1-3 Year Index, which is down -3.2%. And today, short-term US Treasury bonds (US 2Y) are providing yield of 2.48% vs. 2.87% for long-term US treasury bonds (US 10Y). That is a lot more interest rate risk for 0.39% incremental yield.

6. Bond returns have exceeded S&P 500 returns in rising interest rate markets.

What!? That’s right. This research note from Verdad Capital shows that between 1970-1982 – a time of rising interest rates and federal fund rates – the S&P 500 was down -6% in “hiking cycle” versus 10-year treasury bonds increasing 3% while the worst drawdown in equities was -43% vs. -19% for 10 year treasuries.

Source: Verdad Capital Weekly Research

In their note they conclude: “Bonds did a better job of offsetting inflation in tightening cycles…The point of this is not that fixed income will outperform equities or that we will repeat the 1970s. The point is that, in hiking environments, the risk-reward for owning equities becomes worse, and investors should look to diversify away from an all-equity book to preserve their capital for a better time.”

There is Still Good Evidence to Keep Bonds in Your Portfolio

In summary, bonds play a role in the portfolio buffering down markets (historically serving as an asset class with positive skew), providing liquidity for rebalancing, and providing more yield than cash. Tactically, shorter duration bonds reduce the risk of higher unanticipated rate increases relative to longer duration bonds. Even in periods of heightened rate uncertainty, there is still good evidence for most people to keep bonds in their portfolios.

If you have further questions, we are always happy to discuss.

Performance data is as of April 14, 2022. Source: Morningstar Direct. Performance data shown represents past performance. Past performance is no guarantee of future results.