Investing in Bonds
Let’s review the four key roles bonds traditionally play in portfolios:
Income
Inflation protection
Capital preservation
Diversification from stocks
Income
Bonds provide a predictable source on interest income, however Bonds today produce far less income (a.k.a. yield or dividends) than in years past. The next chart illustrates the impact this has had on income generated by stock/bond portfolios.
Dividends are an important, but not primary, driver of stocks’ total return. Yields comprise most of bonds’ expected returns. Tumbling yields have reduced the expected returns of portfolios that include bonds.
Inflation Protection
Not since the 1970s have bonds looked so unappetizing relative to inflation. Add the specter of rising rates, and it’s natural to wonder about the current case for bonds.
Other than a small subset of the bond universe – Treasury Inflation-Protected Securities (TIPs) benefit from inflation and are in our portfolios – inflation far outpaces bond yields.
Capital Preservation
Stocks are notoriously volatile over shorter time periods. Once we push horizons out further (5+ years), the probabilities greatly favor investors that their $1 will be worth $1, and often much more.
However, for those taking distributions, a portion of the portfolio cannot look long-term. Stocks’ short-term uncertainty is too perilous to meet predictable monthly income needs in the coming years.
Here, bonds’ reliability is crucial. In most market environments, bonds preserve their value. Investors can satisfy near-term distribution needs with bonds and leave stocks untouched during their frequent periods of stress.
Diversification from Stocks
Non-correlation between stocks and bonds improves performance a couple of ways: it lowers portfolio volatility and enhances rebalancing.
An allocation to bonds during the above stressful periods raised the performance floor on an otherwise all-stock portfolio. When a portfolio declines 33%, it must climb 50% to return to even. When a portfolio declines 20%, it must climb 25%.
Diversification also helps us be opportunistic. While stocks are down, we look to sell bonds and buy stocks to rebalance portfolios back to their target allocations. Bond values often rise during stock declines (the inverse effect of higher rates lowering bond prices), so in a perfect world we sell high on bonds and buy low on stocks.
No Free Lunch
There is no free lunch in investing. When we look at bonds’ roles, we see tradeoffs. Emphasizing one often means reducing the potency of others. For example, to increase income, you have to assume more risk, e.g. buy corporate bonds from less credit-worthy issuers. The same pressures that can cause stocks to tumble are likely to cause those bonds to suffer as well.
Our bond portfolios today look quite different than they did even five years ago. The main change is a deemphasis on income production. With yields low across the bond universe, the upside of trying to increase income does not strike us as worth the risk of less reliability during stock market stress.