Why Own Bonds?

Gavin Stephens

Stephens, CFA

Portfolio Manager

9-1-18 -

“Well-managed bonds should deliver three crucial benefits to an investor's portfolio: steady income, portfolio diversification, and capital preservation.”

The first half of 2018 has been tough for bond investors. Increased economic growth and inflation expectations have pushed interest rates higher, causing broad price declines across fixed-income markets. And while investors should welcome these higher rates—and the prospect of higher bond returns—the process of rising rates has created some negative price performance. Indeed, as measured by the Bloomberg Barclays US Aggregate Index, fixed-income returns have been a negative 0.96% YTD through 8/31/18.1 Bonds have also significantly underperformed stocks for extended periods. For the last five years, the U.S. aggregate bond market has produced an annualized total return of 2.10%. Large-capitalization U.S. stocks, on the other hand, have produced an annualized total return of 15.8% over this same period.2

Such results might lead investors to question whether they should own bonds at all. In fact, with interest rates only recently off historic lows and many bond prices near historic highs, it is more than reasonable for investors to expect limited near-term returns from their bond portfolios. The question, then, is this: "Why own bonds at all?"

Although we acknowledge today's challenging fixed-income environment, we strongly advocate for the continued inclusion of an actively managed, well-diversified bond portfolio as part of an investor's asset allocation. For despite the challenges raised above, well-managed bonds should deliver three crucial benefits to an investor's portfolio: steady income, portfolio diversification, and capital preservation.

The Importance of a Fixed Income Stream

Owning a bond is equivalent to loaning money. In return for offering someone—or, more specifically, a government or a business—your money, you expect to receive not only your money back but also interest payments along the way. For example, a $10,000 U.S. Treasury note bearing coupons of 3% and a maturity date of June 15, 2028 represents a 10-year loan to the U.S. government in exchange for interest payments of 3%, received semiannually.3 Those semi-annual payments

provide the steady income that defines the "fixed" part of fixed income. As a bond investor, or a lender, you can expect this specific stream of income for as long as you own the bond. In other words, the bonds in your portfolio are effectively outstanding loans for which you should receive interest. These loans are constantly at work for you, accruing interest every day and paying you predictable income throughout the life of the bond.

1 Bloomberg, as of August 31, 2018

2 Bloomberg; 12/31/12 to 12/31/17. U.S. aggregate bond performance as measured by the Bloomberg Barclays U.S. Aggregate Index. U.S. large-cap stock performance as measured by the S&P 500® Index.

3 Hypothetical bond as of June 15, 2018, intended as a proxy for current 10-Year U.S. Treasury note.

Although this characteristic may seem obvious, the income-producing nature of bonds provides at least two immediate benefits. First, a fixed income allows investors to more accurately match cash flows to cash needs. For example, consider an investor with a known federal-tax liability that she plans to pay in quarterly estimates. With a predictable income stream generated from a high-quality bond portfolio, this investor could match her interest receipts to provide sufficient funds for her quarterly tax payments. This same investor might also match the maturity dates of her bonds to expected tuition payments for her college-age children. These examples are two basic ways in which investors can use bonds to match assets to their liabilities.

The income-producing nature of bonds also enhances a portfolio through the power of reinvestment—an additional and potentially powerful source of increased investment returns. For unlike assets with no predictable income streams, bonds provide regular interest payments that can be reinvested to earn additional interest. This practice of earning interest on interest can be particularly beneficial in the context of rising interest rates.

As an example, consider the Treasury note mentioned above, bearing 3% coupons and maturing June 15, 2028. Display 1 below shows the income produced over this life of this bond reinvested at various short-term interest rates. At one extreme, if an investor chooses not to reinvest coupons—presumably by spending his income—the interest received on the bond equals only the coupon payments. Such use of these interest payments reduces the overall compound return of the bond to 2.66%. On the other hand, an investor who is able to reinvest his coupon payments can increase his return over the life of the bond. If he reinvests his coupons at a rate equal to his coupon, he will earn a compound return of 3.0%—a return equivalent to the original yield to maturity. If he reinvests his coupons into higher-yielding securities, he will increase his overall compound return on the bond to above 3%.

As this example shows, a bond’s income stream offers investors the option of enhancing their returns through disciplined reinvestment of that same income. The option to reinvest income is especially valuable in an environment of rising short-term interest rates: each consecutive coupon received can be reinvested into higher yielding securities, thus enhancing the overall compound return on the initial bond investment.

Bonds to Offset Equity Risk

Investors may eschew bonds because of their limited return potential relative to stocks. But while many investors claim that their goal is to maximize returns, their more accurate goal is to maximize returns without taking too much risk. To achieve this more realistic goal, a bond portfolio is crucial. See, for example, Display 2 below that illustrates the correlation coefficients of several fixed-income asset classes to U.S. large-capitalization stocks, as represented by the S&P 500® Index. Correlation coefficients range from -1.0 to +1.0, with -1.0 representing an exact negative move in market value (asset X increases 1.0%, asset Y declines 1.0%) and +1.0 representing an exact positive move in market value (assets X and Y move in equal amounts in the same direction).

As the display shows, over the 10-year period from 2008 to 2017, all fixed-income sectors except for corporate high-yield bonds displayed negative correlation to the U.S. stock markets. Investors received the greatest diversification from investments in long and intermediate U.S. Treasury bonds. Over this period, a portfolio of high-quality bonds—such as U.S. Treasuries—provided portfolio ballast in periods of stock-market stress with returns moving in the opposite direction of U.S. stocks. An allocation to such a bond portfolio would have prevented an investor from seeing losses across her entire portfolio, thus making short-term stock-market declines more tolerable. Maintaining an allocation to bonds is therefore crucial to helping investors achieve their more accurately stated goal of positive long-term returns with tolerable levels of risk.

Bonds also play a special role in recovering from the roughest of bear markets. Displays 3 and 4 show how two portfolios—one invested 100% in stocks and another in 70% stocks and 30% bonds—would have held up after two relatively recent and sharp declines in the U.S. stock market.4 In each case our 100% stock investor would have recouped his losses over several years by maintaining his stock investments. However, six years elapsed from the beginning of the “dot-com” bust in 2000 before our 100% stock investor was made whole, while four elapsed after the 37% stock-market plunge of 2008 before this same investor recovered his initial portfolio value. Moreover, this investor would be made whole only if he could stay invested over these periods—an emotionally challenging, and somewhat unlikely, outcome for someone who has endured such losses.

A modest allocation to bonds can shorten the recovery from such nasty bear markets. Two factors make this possible: the historically negative correlation on high-quality bond returns to stock-market returns and the effect of disciplined rebalancing. Consider, for example, if our investor had experienced the same two bear markets, but rather than holding a portfolio invested solely in stocks, he had allocated 30% of his portfolio to high quality bonds and 70% to stocks. This investor would have recouped his initial portfolio value more quickly than our 100% stock investor—four years following the “dot-com” bust and two years following the decline of 2008.

In both examples our hypothetical investor benefited from bonds’ negative correlation to stocks (earning over 13% from his bond portfolio in the first year of each market decline) and the positive effects of portfolio rebalancing.5 Because this investor owned bonds as part of his portfolio, not all of his portfolio would have suffered losses during these difficult periods. In fact, his bonds would have provided stability within the portfolio and therefore the option to sell bonds and buy stocks at lower prices. This process, achieved through regular portfolio rebalancing, would have increased his returns and thereby decreased his recovery time in both periods. Only with the ballast of a bond portfolio would that have been possible.

The Enduring Role of Bonds

Investors should not invest in bonds to maximize long-term returns. Rather, investors should own bonds to achieve desired investment returns while assuming tolerable levels of risk. To achieve the latter goal, we believe that bonds should remain an integral component of investor portfolios now and in the future. As sources of income, diversification, and stability, bonds provide important balance to an investor’s overall asset allocation. And while recent fixed-income returns are far from spectacular—largely driven by the process of interest rates rising off of their post-financial-crisis lows—the return of more normalized interest rates should only enhance the enduring desirability of bonds within investor portfolios.

4 Annual returns track the following indexes: Stock returns—Ibbotson Associates, Common Stocks for periods through 1943, Standard & Poor's, S&P 500® Index for all later periods. Bond returns—Ibbotson Associates, Intermediate Term Government Bonds for periods through 1976, Citigroup 1-10 Yr Treasury Bond Index for all later periods. Annual rebalancing assumes the account is rebalanced to its target asset allocation at the end of each calendar year. Returns and rebalancing do not take into account transaction costs or any other fees. This material is for education purposes only. Past performance is no guarantee of future results. 5 See footnote #4.

The information provided in this material should not be considered as a recommendation to buy, sell or hold any particular security. This report includes candid statements and observations regarding investment strategies, individual securities, and economic and market conditions; however, there is no guarantee that these statements, opinions or forecasts will prove to be correct. Actual results may differ materially from those we anticipate. The views and strategies described in the piece may not be suitable to all readers and are subject to change without notice. You should not place undue reliance on forward-looking statements, which are current as of the date of this report. The information is not intended to provide and should not be relied on for accounting, legal, and tax advice or investment recommendations. Investing in stocks involves risk, including loss of principal. Past performance is not a guarantee of future results.