If you hold bonds in your investment portfolio, you’ve likely noticed that they experienced negative returns in second quarter this year.
Bond prices go up when rates go down, and rates have been doing just that since the Reagan Administration. Back in 1982, 10-year Treasuries were paying 15%, and after 30 years of steady decline, they dropped below 2% last year and trended down slightly for the first part of 2013. This remarkable three-decade drop in interest rates has been described as the ultimate bull market in bonds, perhaps the most rewarding period for bond investors in all of investment history.
In second quarter, we experienced a rise in interest rates as investors began to anticipate the end of fed’s bond-buying program which have kept interest rates artificially low. Bond prices, as we would expect, declined when rates rose. At the same time, U.S. stocks are up, in aggregate, substantially this year. So the obvious question is:
Why should we have a portion of each investment portfolio in bonds?
The purpose of bonds in an investment portfolio is not to generate high returns–the past 30 years notwithstanding. Bonds protect against the worst kind of market risk–the times when stocks suddenly, unexpectedly plunge. The last time stocks took a nosedive, in 2008, U.S. equity markets seemed to be sailing toward another year of gains and bond prices were experiencing 30 year lows. Why own bonds in an environment like that? Yet by the end of the year, a mixed portfolio of bonds had achieved a 5.24% positive return, while stocks were losing 37%–meaning bonds outperformed stocks by more than 42 percentage points. In 2000, 2001 and 2002 when stocks dropped 9.11%, 11.89% and 22.10% respectively, bonds rallied to give investors returns of 11.63%, 8.43% and 10.26%. Over time, investors holding bonds enjoy a smoother market ride, and experience fewer losses during market downturns.
More importantly, having bonds (and cash) in your investment portfolio gives you options if and when stocks fall. If you need income, you can liquidate the bonds, rather than having to sell stocks at a loss. If the prices of stocks drop to the point where stocks become a screaming buy, you have some money set aside to rebalance and buy at bargain prices to make up some of the losses. And having a diversified portfolio including both stocks and bonds helps you control the level of volatility to which your portfolio is exposed.
As interest rates reverse themselves, and yields move up, you will experience losses in the bond portion of your portfolio. There are ways for us to manage this risk by ensuring that all bonds are short- and intermediate-term and maintaining diversification across multiple sectors of the bond market. But as we focus on meeting your financial goals, bonds are still your best protection against the volatility of stock market returns. We don’t know what the markets are going to do next and when or how quickly interest rates will rise, so the most prudent course is to keep protecting you against the possibility that another 2002 or 2008 is lurking somewhere around the corner.
Vanguard has aggregated data comparing the worst bond bear markets with the worst stock bear markets. The data shows that bond losses have never reached the lows of stock market losses. Click here to view the Vanguard report.
Another report from Vanguard compares multiple asset classes for the diversification value relative to stocks. It shows that investment-grade bonds have provided the best diversification tool over time. Click here to view the report on bonds as diversifiers for stock.
A recent article in Advisor Perspectives compares the effect of the 2nd quarter interest rate drop on the financial plan of a retired couple invested in bonds. Click here to read the Advisor Perspectives article.
Portions of this post were adapted with permission of financial columnist Bob Veres.