After a summer of falling market values amid fears of Fed “tapering,”
news of wobbly sovereign debt in Greece, Cyprus, Slovenia, Puerto Rico
and elsewhere, plus bankruptcy filings in Detroit, San Bernardino, and
Jefferson County, Alabama, many investors are reducing the percentage of
bonds in their portfolios or avoiding them all together as an asset
class. Why the trepidation? Given the current market conditions, yes,
many types of bonds will perform poorly. This poor performance can be
exacerbated for those who have been chasing yield or those who have
sought to invest in bonds via pooled investment vehicles (i.e. mutual
funds). Nevertheless, there are still very good reasons to include
bonds as an asset class in investors’ portfolios, provided they are
bought prudently and managed capably. In short, not all bonds will
perform the same. Investors and their advisors need to understand how
to find the good ones and avoid the bad.
The fundamental reason for including bonds in virtually any investment portfolio is that they are a great diversifier, reducing volatility and providing an important source of liquidity. Historically, returns from bonds are only modestly correlated with those from stocks, meaning that they often do well when stocks do poorly, and vice versa [see table]. When asset classes exhibit low correlations, overall investment return volatility is reduced and risk-adjusted returns are increased. As you can see from the table this has been the case for the past ten year and much of our country’s financial system existence. Bonds belong in investors’ portfolios for the long run.
Thoughtful long-term investors need to look beyond the performance of the past quarter, which was the result of a market that had become much too dependent on continued Federal Reserve monetary stimulus delivered through bond purchases. Bond prices had been driven to historic highs, and yields to historic lows, by a flood of Fed money intended to goose economic growth. Last quarter’s market price decline should be viewed as a much needed correction, but not an argument for dumping bonds in their entirety as an asset class.
Remember, bonds are a contract in which investors’ loan money with the promise that principle will be returned plus interest payments. Losses on bonds are only realized when a bond is sold at a lower price than where it was purchased or in the event of default. This highlights the necessity of assessing credit quality effectively to avoid defaults, or hiring a manager that can do that for you. Moreover, investment grade bonds provide an important source of liquidity that is vitally important in times of volatility, market dislocations or changes in personal circumstance.
As a matter of fact, bond holders who adhered to two basic principles have done very well, both over the longer term and by comparison with their investing peers over the past quarter. The two saving principles are:
1. Care in the selection and oversight of credit. The primary objective of buying bonds is to be repaid – an elementary objective that is often ignored by buyers of dicey securities offering higher yields. Think Puerto Rico bonds. As to market-price performance, it is basic to bond mathematics that longer maturities are correlated with greater market-price volatility. When investors scrambled for the exits in response to Chairman Bernanke’s musings about tapering the pace of the Fed’s bond investments, the inevitable result was a bit of panic and a consequent price decline.
2. Strict discipline as to maturities and portfolio structuring. The worst losses have been sustained by investors who, in their lust for additional yield, invested in bonds of dubious credit quality and lengthy maturities or a combination of both. Holders of bonds with shorter maturities incurred much smaller (or no) paper losses and will continue to earn reasonable income until their bonds mature, at which time they will be able to reinvest at higher yields and produce even greater recurring income. When done in this manner, bond investing is both rewarding and a great diversifier against stock price volatility.
Finally, when compared globally, the U.S. economy continues to improve, albeit at a modest pace. The Eurozone is also slowly coming out of recession, although the economic vitality of the area is impaired by high social overhead costs and by the still-unresolved financial difficulties of the southern area economies. Economic conditions in China and in the emerging markets are unstable and expose investors to sovereign risk. Given this backdrop, rising stock pricing potential would appear to be limited. So where is an investor to turn? We can’t help those who are looking for The Next Big Thing, but for those of you who are looking for prudent, consistent investment performance and capital preservation, we suggest that you take a good, disciplined look at high-quality bonds with reasonable maturities. We think you’ll find them still worth the investment.