What role does fixed income play in your portfolio? How do we squeeze return out of bonds in today’s ultra-low interest rate environment? We have often discussed or written about the topic of the premium that equity investors may receive over time in exchange for putting up with the volatility in the stock market. Although the stock market has outperformed the bond market by 4.5% per year since 1974, as with anything, there is never a free lunch. Equity investors must accept a significantly higher degree of volatility investing in stocks in order to achieve the wonderful long-term returns. We have adopted a phrase around here called “volatility is your friend” to support this. Be on the lookout for a future blog post on this topic by Matt Callahan.
What can sometimes be underappreciated is the role that bonds play in an investor’s portfolio. We view bonds as the ballast or buffer against the volatility of the stock market. While owning a stock is akin to being an owner of the company, owning a bond is more like being the bank and lending money to a company. Historically, bonds have not been as volatile as stocks in a normal market cycle, which is why the premium for owning bonds is not as great as the premium for owning stocks. However, we believe there is a place for bonds in most portfolios.
Let’s start with the explanation of how you make money with bonds. Bonds have two components of return: price and yield. These two components have an inverse relationship to each other. While interest rates are very low right now, prices of bonds remain high. This might seem confusing, so I ask you to recall March 2020. Most novice investors were selling stocks because of fear and uncertainty in the stock market as prices were going down quickly. This caused a surplus of cash in the marketplace while investors waited on the sidelines for the volatility of the stock market to subside. Many investors sought refuge in bonds, hoping to find a little better yield (interest rate) than the cash in their bank. As massive amounts of money flooded into the bond market, the price of bonds began to rise rapidly which sent the yields of bonds plummeting.
At current levels, interest rates are as low as they have been in generations, leading investors to ask the great question of what they should be doing with the bonds in their portfolio and whether they should be investing in bonds at all. Our view is that bonds represent the safe-haven portion of your portfolio. This is the money you can count on to be there if you need it and to not fluctuate in price as much as a stock would. Even if stocks are down in price significantly, you want to know that your bonds are retaining their value or even gaining in value in this situation. This is exactly what happened in March 2020 and the 12 other bear markets since World War II. As the price of stocks is going down, the price of bonds usually goes up!
Remember, bonds are the safe haven of your portfolio and allow you to weather the storm and give your equities time to recover. The average bear market lasts about 3 years (this is the average duration of the bear markets in the U.S. since World War II) and during this time, the stock market goes down about 30% in value. This is the reason that, for a retiree, we like to keep at least 3-5 years of distributions from the portfolio in bonds which gives ample amounts of money to withdraw when you need it while you are waiting for the stock market to recover. Buying short-term, high quality bonds would help accomplish this goal.
The problem today is that cash is paying essentially 0% and short-term, high-quality bonds are also paying next to nothing. This caused us to scrutinize the bond market and look for opportunity without taking undue amounts of risk. One opportunity we found is investing in corporate debt of well-run companies like Apple, Amazon and Microsoft. The great companies of America and throughout the world have very strong balance sheets having learned the hard lessons from the economic crisis of 2008. These companies are taking advantage of low interest rates to issue debt and they are using the capital from the debt issuance to further advance and grow their businesses. Because corporate debt is not backed by the full faith and taxing ability of the U.S. government, the interest rate of these bonds must be a little better to entice investors to place their capital there. Ratings agencies such as Moody’s and S&P do a good job of helping investors to identify where there is risk worth taking versus risk that should be avoided. We still like high quality debt and view this as an important standard to maintain.
Another area we have studied is the yield curve. Bonds can be very sensitive to movements in interest rates. When rates go up, bond prices go down. The longer the duration of a bond the more it goes down when rates go up. While we still view short term bonds as a safe place to invest, investors are getting penalized for being too short in maturity. We have carefully analyzed this and tried to position the duration of our bond portfolio at 5 years or less. When you look back at 2020 and 2008, bonds acted as a wonderful hedge against the precipitous drop in the stock market up 7.51% and 5.24%, respectively (as measured by the Barclays Aggregate Bond Index). While we don’t want to be overweight to long term bonds a sweet spot may exist in the short to medium term space offering patient investors wonderful opportunities.
In addition, investing in debt of foreign companies and governments is a good way to get exposure to different countries, companies and yield curves. This added diversification can enhance what is happening in the bond portfolio. It’s also a good way to diversify against currency risk (the risk that the US dollar will decline in value). As with stock investing we believe that international diversification is important when it comes to the bond market as well.
Lastly, a word on rebalancing. Having bonds in the portfolio allows an investor to take advantage of disruptions and price dislocations in the stock market. When stock prices are falling rapidly, like we saw in early 2020, bond prices were up. This caused an imbalance in asset allocation in many portfolios because the bonds represented more of the portfolio than they should have due to the price appreciation of this asset class. Our investment process triggered us to rebalance the portfolio by selling a portion of the bonds (“sell high”) and redeploying the proceeds to purchase stocks (now the asset class on sale, “buy low.”). This systematic, disciplined approach is a wonderful way to control risk and ultimately improve performance over time.
Remember, not all bonds are created equal so it’s important to understand what you own in each of your funds. In particular, we have observed that many active fund managers have been attempting to stretch their yield and return by extending duration, reducing credit quality or both. This introduces more risk to the bond portion of your portfolio and may have adverse consequences later on. We take great care in understanding the bond holdings within your portfolio and understand how they work with the other investments in your portfolio.
If you have questions or simply want to talk more in depth about this topic or any other topic we write about, please feel free to give the office a call.