Do Bonds Still Have a Role in Your Portfolio?
posted on April 11, 2014 11:30
Bonds play the specific role of hedging against equity risk (volatility) in a cost-effective manner. The low volatility of bonds compared to stocks provides that stability.
Daily Stock and Bond Returns
Data Source: Morningstar Direct
High-quality bonds protect you when you need it the most. Savant utilizes high-quality bonds in a globally diversified bond allocation spread across many sectors and countries.
High-Quality Bond Performance During Equity Bear Markets
Data Source: Morningstar Direct, Reflects Ibbotson Intermediate-Term Government Bond Index
Rising interest rates (yields) can cause bond prices to fall. However, higher interest rates can work to your advantage in the long run. The exhibit illustrates the impact of a 1% rise in interest rates for a hypothetical intermediate-term bond portfolio (4.5 year duration). The change would cause a negative return in year 1 but would break even during year 2 (all else being equal). Despite the initial decline, the income is reinvested at higher rates causing the value to recover quickly and in time surpass that of a portfolio with no change in yield.
As a general rule of thumb, the duration is equal to the change in portfolio value associated with a 1% change in yield. For example, Savant’s typical bond portfolio duration is about 4.5 years, so a 1% rise in interest rates should be expected to cause an initial decline of about 4.5%, but the higher yields work to offset that decline over time.
Hypothetical Impact of One-Time 1% Increase in Interest Rates
Notes: This hypothetical intermediate-term bond fund started with a yield of 2% and 4.5 year duration. Yield change assumed to be from 2% to 3% six months into year 1. For simplicity, duration was assumed to remain unchanged, but in practice, as yields change, duration also changes. For purposes of illustration, we assumed no changes to yields in subsequent years.
Bond yields are low and could stay that way for some time. Treasury yields have historically been anchored to the Fed Funds rate. Historical evidence suggests yields may not go much higher until the Fed raises rates. The Fed is slowly unwinding Quantitative Easing (QE) and is not likely to begin raising rates until some time after that.
Historical Fed Funds and Treasury Yields
Data Source: St. Louis Federal Reserve
If rates do suddenly go higher and trigger a bear market for bonds, it will be nothing like an equity market shock. Bond bear markets are much tamer and shorter than stock bear markets.
Bond Bear Markets Stock Bear Markets
Data Source: Morningstar Direct; Diversified Bond Portfolio: 50% Barclays U.S. Agg Bond Index / 50% Barclays U.S. 1-3 Yr Govt/Credit Index, Monthly Data. Stocks: S&P 500 Index Total Return, Daily Data
Bond portfolio returns over a forward-looking 20-year horizon will likely be lower than the long-term historical average shown and much lower than recent history given that our starting point for yields today is so low. Returns are likely to be closer to those in the Pre-1980s period shown. Despite lower expected returns, a diversified bond allocation still plays an important role in a portfolio.
Historical vs. Expected Bond Returns
Data Source: Morningstar Direct; Barclays U.S. Intermediate Government Index