One of the conversations I keep having over and over with investors is whether they should have Treasury bonds (or Bonds of any kind) in their portfolio.
It’s a relevant question because most portfolios have a bond component. The traditional asset allocation strategy is 60% in equities and 40% in bonds and cash. Bonds benefit a portfolio by diversifying risk and improving performance at a given level of risk.
The concern is that with interest rates at historic lows, Treasury bonds are guaranteed to lose value when rates rise. The reason is that newly issued bonds carry a higher interest rate than existing bonds in a portfolio, even though the income stream is unchanged.
What To Do
In our view, certain types of bonds still deserve to be in most portfolios for the critical reasons mentioned above, but the type and duration of these bonds matters more than ever.
In this market environment, a bond allocation requires much more attention than it has in the recent past. Going forward, bonds will likely need to be bought and sold and hedged more frequently – much like equities – in response to or anticipation of movements in interest rates. If Treasury bonds aren’t actively managed, investors will be in for a rude awakening when rates finally do rise.
To succeed when rates are rising, it’s absolutely essential to realize that not all bonds are created equal. U.S. Treasury instruments – bills, notes and bonds – are considered the safest fixed-income investments because they carry the implicit backing of the U.S. government. Other government-backed or sponsored bonds, such as munis and agencies, are also safer by comparison, but offer very low yields.
However, there is a whole range of other bonds – corporates and junk bonds, that do offer higher yields with slightly more risk. In addition, there are many new, bond-like instruments that pay significantly higher rates, albeit with different elements of risk. Treasury Inflation-Protected Securities (TIPS), Mezzanine Debt and High Yield Munis are all types of Bonds that should play a role in the next generation Bond Strategy.
All of these fixed-income investments are subject to the same dynamic: As interest rates rise, their value will decline, while the interest payment to investors remains the same over the duration of the investment.
Thus, the investment challenge is trying to own bonds of varying types and duration. Over the past 35 years, buy-and-hold proved to be an outstanding bond strategy. Declining rates have meant that existing bonds could have been sold in the secondary market for more than investors purchased them in the first place.
Three Reasons To Have Bonds In Your Portfolio
Despite the challenges ahead for bondholders, there is no question – none at all – that most investors need to have some form of bonds in their portfolio. To do otherwise would be a mistake. Here are the three reasons why it isn’t dumb to have individual bonds in your portfolio.
- Treasury Bonds have historically been negatively correlated to stocks. Traditionally, as stocks go down, Bonds go up! Bonds provide much-needed balance and diversification to a portfolio. For that reason alone, they are an essential part of an investment strategy.
- Bonds offer permanent and definitive returns. Everything about a bond is known the day it is purchased – the duration and interest payments. If the bond is held to maturity, movements in the financial markets are irrelevant, so long as the income stream can meet the investor’s cash needs. Any bond allocation should be carefully spelled out a well-articulated financial plan.
- Bonds are a safe harbor. When there’s uncertainty in the market for economic, political or other reasons, investors often react in knee-jerk fashion and move money into bonds. This flight to safety happens whenever there is increased risk or volatility in the stock market. Historically, bonds are steadier and aren’t subject to the same volatility. They also don’t produce the upside that equities can deliver over the long term.
With the current 10-year Treasury yield at a historic low, you are likely to lose money when interest rates rise, OR if the rise in the cost of living exceeds 1.75%. The only way that wouldn’t happen is if interest rates stayed at their current rates or even declined, or we experience full blown deflation. That’s highly unlikely in the longer term.
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When it comes to bonds, the next 35 years will be very different than the past 35. Despite that, certain bonds are definitely worth having in your portfolio. The key is: 1) Having the right mix in your portfolio. 2) Paying close attention to the inherent risks in those bonds. 3) Knowing when to change your strategy in response to changes in Interest Rates.