A Case for Owning Bonds in a Volatile MarketSubmitted by Younity Wealth Partners on November 22nd, 2016
Updated: November 22nd, 2016 by Kara Downing, CFP®
We received the following question from a prospective client last week, and we thought the context of it was appropriate for anyone questioning the merit of bonds these days. Read on for our response.
Question: When the bond market tanked recently, did you move your clients’ bond holdings into cash or alternative investments?
First, I have to make a disclaimer: Questions concerning investment philosophy and strategy require an in-depth discussion that a blog post or article can’t replace. Younity Wealth Partners spends a great deal of time educating its clients about financial concepts in ways they can better understand. Without knowing your past investment experience, or level of comfort with certain investment terms and concepts, we run the risk of speaking different languages (in a matter of speaking). With that said, I’ll do my best to answer this question, at least partially, here and welcome any further questions you may have.
The Short Answer:
There is an inverse relationship between bond yield and bond price, so longer duration bonds tend to be more volatile and experience greater loss when interest rates rise. In anticipation of rising interest rates, we, as a firm, have have been shifting more dollars to shorter duration fixed income over the course of this year. This proved to be a positive move, at least in the near-term, as shorter duration fixed investments outperformed the Bloomberg Barclays US Aggregate Bond Index in the last few weeks.
With regard to performance expectations for bonds, it’s important to maintain a long-term focus and keep concerns about rising rates in check. Future performance will depend on what policies President-elect Trump actually pursues and how much support he receives from the Republican-led Congress. The fear about the impact on bond investments may be overstated, despite the spike after the election, and possible raise in short-term rates by the Federal Reserve in Dec ‘16/Jan ‘17.
As a general rule, we do not make sudden shifts in a long-term investment plan in response to short-term market movements. We also do not attempt to “time the market,” which is impossible to do consistently and successfully over time. Evidence strongly suggests that investors should resist the temptation to jump ship after market turbulence, and stick with a buy-and-hold approach to avoid missing out on long-term gains.
*Read on for additional thoughts on why we believe bonds still have a place in portfolios.
The Case for Owning Bonds in a Rising Interest Rate Environment
After the last few weeks of bond market woes, it’s tempting to have a kneejerk reaction and decide that owning bonds no longer has merit. Selling low, rather than selling high, might even seem like a respectable solution when it looks like things will never improve.
However, it’s important to avoid locking in your losses, even when the best investments go through challenging periods. Not all investments create positive return all the time, and they really shouldn't if you're properly diversified. “Diversification means always having to apologize that some part of the portfolio is underperforming at some time.”
Part of our human nature is to focus more intently on the negative, which is the crux of this question. It takes us twice as much effort to get excited about something positive than to gnash our teeth about something negative. It's what advisors probably struggle with most - people being people. We advisors do our best work when we save investors from making emotionally-based decisions when it comes to their portfolio.
This quote tidily describes what you should expect from diversification. It's not a magic solution to high returns all the time. It simply says, some investments will be up and some investments won’t, but overall, you should see a general trend towards growth and positive returns. And that will help you stick to a game plan by not fretting over the ups and downs.
(If every investment in your portfolio is working well, it usually means one of two things: you’ve got incredible luck or you’re not actually diversified. I’d speculate the latter is actually the case.)
At Younity, we believe there are very valid reasons to continue to own fixed income for at least a portion of our clients’ portfolios. Whether or not bonds have a place in YOUR portfolio, though, depends entirely on what your goals are.
If you’re owning bonds for income, then looking beyond just the Treasury market offers many attractive opportunities for a well-diversified bond portfolio to help meet income objectives. If the purpose of owning bonds for you is to provide an anchor of safety in a volatile market environment, we believe suitably conservative bond investments still serve that purpose.
While it is true that the value of most bonds and bond funds fall when interest rates rise, not all bond funds react in exactly the same way. For example: our diversified bond portfolios have exposure to Treasurys, corporate bonds, municipal bonds, cash, and other government debt, each of which performed differently in the latest bond market drop. Our holdings are investment grade, globally diversified, and have varying maturity dates.
Better questions might be, “What kind bonds do you own? What is the average credit quality of the bonds you own for your clients? Are the bonds classified as US, international, or global debt? What is the average duration of your bond portfolio? In which types of environments should these bonds perform well? Under what conditions might these bonds struggle? How do you determine which investments are appropriate for me?”
(I hope that list of questions helps you understand why our philosophy of planning around your goals means you and Younity make better wealth management decisions together.)
If you’re a long-term investor in bond funds, understand that fund managers are constantly reinvesting proceeds from bond coupons, maturities, and sales of lower-coupon bonds into higher-yielding bonds. Over time, that can boost the income you earn from a bond fund, meaning you can potentially recover from losses through increased returns, and the returns that you end up getting may not look as bad as you might have feared.
What About Alternatives?
Alternative investments, broadly defined as those that are not stocks or bonds, are not appropriate for everyone. They can be costly and risky. Each client’s financial plan is the determining factor in which investments we recommended.
For clients who’ve already retired, we are comfortable allocating part of the portfolio to alternatives to the degree in which those assets are not required to meet wealth management goals. In other words, if you can afford to take the risk, then an investment to this asset class may be an appropriate choice for you – but there is no free lunch. The potential for higher returns means accepting higher risk and volatility.
Again, like many other aspects of this question/response, we’ve only scratched the surface with this conversation.