Mitigating Risk: How Bonds Play a Crucial Role in Your Portfolio
Global equities had mixed performance in the third quarter with large U.S. stocks inching higher and small U.S. stocks falling 2.4%. Foreign stocks struggled in the face of trade negotiations and ongoing tariff disputes. Real estate was a strong performing asset class, rising nearly 6% as interest rates declined, reducing financing costs. As has been the case for much of the year, political headlines remained prominent in the U.S. news cycle as the 2020 presidential election looms on the horizon and an impeachment inquiry got underway.
Asset class returns for the quarter and year-to-date were as follows:
As the U.S. stock market hovered around recent highs, yields on newly-issued bonds returned to near historic lows as the Federal Reserve (Fed) cut interest rates for the second time this year. In September, the Fed’s policy-setting committee lowered the interest rate at which banks lend overnight funds to other banks by 0.25% to a range of 1.75% to 2.00%, a move that was widely anticipated. Importantly, the Fed only sets the target interest rate for very short-term debt, and the current target rate is very low by historical standards (the 10-year Treasury note rate since 1970 is shown below, which is a general benchmark for intermediate-term bond yields). It is extremely difficult to accurately predict whether the Fed will lower or raise rates on a consistent basis. Just last year, the general consensus was for the Fed to raise interest rates two times in 2019, which proved to be the opposite of what actually transpired.
The decline in interest rates has been a tailwind for bond investors this year, as prices rose on current bonds, juicing total returns. The return to lower yields has, however, led some investors to again question the value of holding bonds in investment portfolios, especially given the prolonged bull market in equities.
We strongly believe that bonds play a crucial role in an investor’s overall portfolio — to mitigate portfolio volatility, provide liquidity with some current income, and hedge against inflation.
Mitigating portfolio volatility. Even in the current low interest rate environment, bonds serve a key purpose — to buffer the more volatile equity portion of an investment portfolio. Historically, interest rate cycles have had a greater impact on bonds than stocks. Nonetheless, it is important to note that a bad year in short-to-intermediate term bonds is very different from a bad year in stocks. Since 1973 there have been only two years in which bonds (as measured by the Barclays U.S. Government/Credit Bond Index-Intermediate Term) have had negative returns: 1994 (-1.9%) and 2013 (-0.9%). A bad year in bonds is a decline of one to two percentage points. A bad year in stocks is a decline of 30 or 40 percent, as we experienced during the financial crisis of 2008-2009 (it is important to note that during the financial crisis years, intermediate-term bonds were up 5.1% in 2008 and 5.2% in 2009, providing a much-needed offset to declining equity prices). Similar flights to safety were seen during stock market selloffs in 1990 and 2000-2002.
Liquidity for withdrawals and rebalancing of portfolios. An allocation to bonds can provide “dry powder” to rebalance portfolios during equity market downturns. If a 60% stocks/40% bonds portfolio experiences a decline in stock values and becomes a 55% stocks/45% bonds portfolio, a portion of the bonds can be liquidated and used to purchase stocks at lower prices, bringing the portfolio back in line with its target allocation. In addition, for investors who are withdrawing money from their portfolio, an allocation to high-quality bonds can provide much needed liquidity.
- Overall return enhancement/interest payments. We do not invest in bonds with the goal of generating high income; however, bonds can provide modest returns to a portfolio through a constant stream of interest payments. Although that interest income is not particularly high for safer, shorter-term bonds, the stable return can provide cash during periods of depressed equity values.
Inflation protection. An investor may be tempted to sell bond holdings and simply hold cash, but those funds would immediately begin losing purchasing power due to inflation. Historically, bonds have provided a return premium over inflation, whereas cash has proved to be a deflationary asset class in the long run.
In managing client portfolios, we intentionally keep bond maturities short-to-intermediate term to limit the negative impact of a quick rise in interest rates. Generally, longer maturity bonds are more negatively affected by rising rates as investors are locked into low rates for longer periods of time. If interest rates do begin to rise again, an investor with shorter maturity bonds can re-invest funds into higher yielding bonds gradually over time, increasing the expected return. We have a strong preference for bonds with relatively short maturities and very little credit risk. Despite the constant stream of investment offerings enticing investors to “reach for yield,” we advise against replacing bonds with high yielding investments (preferred stock, MLPs, high dividend paying stocks, etc.), which often carry much higher risks.
We do not know exactly where interest rates are headed or when such moves may happen, but one thing is apparent: there is much more room at this point for interest rates to rise than there is for them to continue to fall. We have purposely constructed clients’ bond portfolios with the dual aims of protecting capital and hedging equity risk in the event of a sharp stock market selloff. While the very low yields currently available in high quality, shorter-term bonds can be frustrating, we feel strongly that this is the prudent strategy for investors and will leave them well-positioned to take advantage of higher future rates. On the other hand, those who have “reached for yield” by extending their bond maturities or sacrificing quality to obtain more income may be in for a rude awakening. Dowling & Yahnke has always considered high quality, short-and intermediate-term bonds to be the ballast in our clients’ investment portfolios. Given the prospect of higher rates in the future, we think this conservative strategy is more appropriate today than perhaps at any time in the last several decades.
As Dowling & Yahnke continues to grow, we remain focused on building our world-class team. Earlier this summer, Greg Richardson and Mark Wernig became owners in the firm. Both Greg and Mark bring exceptional client service and leadership capabilities to our principal group, which are essential as we continue to expand services to meet client needs. We also continue to grow our advisor team. Olivian Pitis joined Dowling & Yahnke as a Lead Advisor after serving as Vice President and Regional Director at Dimensional Fund Advisors for the past eight years. In addition, Andy Christopher joined the firm as an Associate Advisor following a 10-year career in the U.S. Navy as an officer and F/A-18 Super-Hornet pilot. Both Olivian and Andy bring to our team tremendous experience, work ethic, and passion for serving clients. Additional information about our advisor team is available at https://www.dywealth.com/advisors-and-financial-planning.
We thank our clients and fellow business professionals for their continued trust and support. We encourage you to contact our team with any questions or concerns regarding your finances.