Resetting Bond Return Expectations

“If you understand that the role of fixed income is to be the boring part of your portfolio, then you’re buying short- to intermediate-term bonds and you’re holding on to them. That’s always been the role of fixed income and that’ll always be the role of fixed income.” – Carl Richards

Bond investors have had it pretty good for some time now.  Although interest rates have been on the rise in the past few months, they remain historically low, especially when viewed in the context of the past 30 years or so.

Bonds exhibit much higher volatility at lower levels of interest rates. Income earned on bonds is so low that it’s difficult to offset the price declines when rates rise (remember interest rates and bond prices are inversely related, so as one rises the other falls).

For example, a 1% rise in interest rates leads to larger losses when rates are at 3% than you would see with rates at 6%. You lose some of the cushion that the higher income payments provide at higher rates.

BULL TO BEAR?
From a historical perspective, bond returns for the past 30 years or so have been phenomenal. The biggest reason for this is the fact that interest rates were extremely high in the early 1980s to offset the high inflation that was seen at that time.

Mean reversion teaches us that periods of higher than average performance tend to lead to periods of lower than average performance since the good times can’t last forever. That’s exactly what we may witness with future bond returns.

Take a look at this historical performance data that shows how bonds performed in the 1981-2011 time frame versus the preceding 30 year period of 1951-1981:

During the bond bull market, long-term bonds actually outperformed stocks while high yield bonds came close. Even intermediate term government bonds returned almost 9% per year.

Now look at the right side of the table to see how bonds performed in the 30 year bear market. The returns were much lower across the board for all bond categories.

That could be the roadmap for the future of bond returns. This isn’t a prediction, just an educated observation. Over longer time frames, bonds returns tend to be very close to their corresponding average interest rates. And right now rates are pretty low.

WHAT DOES THIS MEAN FOR BOND INVESTORS?
As with all of your investment decisions, your risk profile and time horizon should be the biggest determinants of the choices that you ultimately make with your bond investments.

It all depends on how fast rates increase, but a portion of the price losses from rising rates can be made up by reinvesting in the new higher rates. So all is not lost for bond investors.

You shouldn’t substitute stocks for bond unless you are willing to change your entire tolerance for risk. You have to understand that you are increasing your risk for large losses by changing your asset allocation more heavily towards stocks. According to Vanguard, the worst bond market loss in history was less than one-sixth of the magnitude of the worst stock market losses.

Let’s look at how a hypothetical portfolio made up of 70% in stocks and 30% in bonds would fair with a large stock market loss at different levels of bond returns:

Higher bond returns similar to those we witnessed in the bond bull market helped cushion the blow from large stock market losses. But at lower bond returns, the stock loss is still cushioned, just to a lesser degree (from -18.6% to -20.4%).

Even with lower returns, bonds can still serve a purpose in a diversified portfolio.

Here what it all boils down to: Why are you invested in bonds in the first place?

If it’s because you got scared out of stocks in 2008 and 2009 then it’s time to reassess your entire investment plan. Remember why bonds are a part of your portfolio and asset allocation. They diversify your stock market risks.

If you are willing and able to handle the larger short-term gyrations of the stock market then maybe you don’t need a high weighting to bonds. Most investors say they have the stomach for large losses until they actually experience them firsthand.

Bonds generally have a very low correlation to stocks (they zig when stocks zag) and they offer you income in the form of fixed cash flow payments.

There are risks in bonds. If rates rise, it will make for a much more volatile ride for bonds. But reaching for yield can increase your risk even more. Substituting stocks for bonds can change your entire risk profile so make sure you understand the risks before you make that change.

It’s no fun to earn lower returns on bonds, but remember why you have them in your portfolio in the first place. Bond investors will just have to reset their expectations.

Sources:
Should Investors Switch from Bonds Because of the Prospect of Rising Rates? (Vanguard)
Morningstar

Now for the best stuff I’ve been reading this week:

• Diversification isn’t broken, it just takes a while (NY Times)
• Jason Dufner is a better celebrity endorser thank you think (Forbes) see also Dufnering (The Telegraph)
• Serenity now…investment advice from Frank Costanza (CBS Moneywatch)
• Successful market timing is an urban legend (Servo Wealth Management)
• 5 ways to tell if your broker is an Al Bundy (Your Wealth Effect)
• The 3 most important words in investing (Motley Fool)
• 10 investment rules to live by (Prag Cap)
• 5 essential financial planning steps for your 30s and 40s (The Chicago Financial Planner)
• Focus on performance not philosophy (Abnormal Returns)
• Clark Howard, the most reasonable financial guru in the bookstore (Slate)
• The back story on the creation of The Behavior Gap (CFA)
• Over 10 years, 90% of Vanguard funds outperformed their peers (Vanguard)

[widgets_on_pages]