Dump Your Bonds? Not So Fast! - Adviser Investments

Dump Your Bonds? Not So Fast!

I can’t blame anyone for raising their eyebrows and asking about their bond investments right now.

A recent CNBC segment on bonds featured a market strategist who said he would “short the whole lot of them.” While he’s not alone in that sentiment, I wholeheartedly disagree. In fact, anytime someone tells you to sell all of anything, you should probably hit the pause button and reassess. In this case, there are very good reasons to hold tight to your bonds.

Diversification Is Not Dead

The high-quality bonds we buy for Adviser Investments’ clients rise and fall in value once the initial investment is made, naturally. But I take great comfort in knowing that when they mature (barring any calamitous events), investors will almost always receive the bond’s face value back and keep the income they earned along the way. You’ll never have the luxury of a guaranteed return of principal when you buy stocks, commodities futures or real estate investment trusts (REITs).

That’s why diversification is critical. Mixing investments among stocks, bonds and cash means that you’ve spread out the risks in your portfolio. Eliminating exposure to bonds from this equation—whether individual bonds or bond mutual funds—removes a source of stability and income generation from your investment toolkit. In a year when we’re expecting greater stock market volatility, such a move could be costly.

The chart below illustrates the benefits of holding bonds over time. The benchmark Bloomberg U.S. Aggregate Bond index, which has been around for 46 years, has only experienced four down years since 1976. Of course, past performance is not a guarantee of what’s going to happen next, but our research has shown that bonds’ current yields are a decent indicator of how they’ll perform over the next five to 10 years. (The benchmark bond index currently has a yield to maturity of 2.46% and yields are trending higher.)

This chart shows calendar-year returns for the Bloomberg U.S. Aggregate bond index. Since 1976, there have only been four years with negative returns.
Note: Chart shows calendar-year total returns for the Bloomberg U.S. Aggregate Bond index. Source: Bloomberg.

Sticking With the Plan

If you and your adviser have determined after careful consideration that, say, 40% of your portfolio should be allocated to bonds to help you achieve your long-term investment goals, the questions are: Other than some short-term underperformance, what’s changed? Do you no longer need the income? Have the bonds suddenly become lower quality? Did they unexpectedly become riskier than the other asset classes they are paired with in the portfolio ?

If the answer to these questions is “no” (and I believe that’s the case right now for most investors), that’s an argument for sticking with your long-term plan. In fact, for income-seeking investors, I’d suggest adding to the allocation on price declines because bonds are now getting what we’ve been waiting for: Higher yields.

There Are (Arguably) No Better Alternatives

If we wanted to sell our bond holdings and seek alternatives, where exactly would we reinvest the proceeds?

Adding stocks means increasing a portfolio’s potential for volatility even though our risk tolerance hasn’t changed. The same could be said for so-called bond alternatives like REITs, dividend-growth stocks (an asset class we are fond of at Adviser Investments, just not as a substitute for bonds) or hybrid investments like preferred stocks.

Moving our bond allocation to market funds or cash doesn’t make sense for most long-term investors, either. Though these options are safer in that they will not decline in value, they’re currently yielding just hundredths of a percent. When we factor in inflation (more on this below), this move appears even less attractive. With cash today, you’re giving up on income and the potential for growth, making it a lackluster substitute for the more dynamic role bonds play in a portfolio.

Why not remain invested and secure in the knowledge that your bond exposure earns significantly more than cash, produces a reliable income stream, carries a defined maturity date when principal will be returned (individual bonds) and typically finishes in positive territory in any given year (broad bond market funds)?

Higher Yields and Lower Inflation on the Horizon

We’ve anticipated for years that interest rates would rise, pushing bond prices down while boosting yields. We have been positioning both our individual bond portfolios and the bond portion of our mutual fund portfolios with that in mind by staying far away from the longest-maturity bonds (which see the most dramatic price declines when interest rates rise).

More recently, we’ve seen inflation hit generational highs, which creates an additional headwind for bond investments (and an even greater one for cash). While higher prices have stuck around longer than many analysts expected, the Federal Reserve will be acting soon to do something about it. We wouldn’t be surprised to see inflation cool down this year and fall back closer to its long-term average level of between 3.5% and 4.0%.

That’s all to say that what’s happening now in the bond market isn’t a surprise. From my vantage point, I expect high-quality bonds will do what they are supposed to do when investors need it the most—provide income and smooth out the impact of stock market volatility in a portfolio.

For more on bonds, check out the “Your Bond Questions Answered” episode of The Adviser You Can Talk To Podcast, which features Director of Research Jeff DeMaso, Quantitative Investments Manager Josh Jurbala, Portfolio Manager Charlie Toole and me.

This material is distributed for informational purposes only. The investment ideas and opinions contained herein should not be viewed as recommendations or personal investment advice or considered an offer to buy or sell specific securities. Our statements and opinions are subject to change at any time, without notice, and should be considered only as part of a diversified portfolio. Mutual funds and exchange-traded funds mentioned herein are not necessarily held in client portfolios. Data and statistics contained in this report are obtained from what we believe to be reliable sources; however, their accuracy, completeness or reliability cannot be guaranteed.

All investments are subject to risk of loss. Past performance is no guarantee of future performance. Discussion of high-quality bonds is general in nature with respect to the asset class. These investments are subject to numerous risks, including but not limited to interest-rate risk, price volatility, default and downgrade of rating subsequent to investment. Principal is not guaranteed. Information comes from what we believe are reliable sources.