Bonds Still Deserve a Place in the Portfolio

Categories: Drivers of Value
Gregg Fisher, CFA

The rise in interest rates over the past few months has led some observers to pronounce an end to a long bull market in bonds. The yield on Treasury bonds maturing in 10 years jumped more than 100 basis points, from 1.63% on 2 May 2013 to 2.64% on 6 August. Year to date through 6 August, the Barclays Capital U.S. 7–10 Year Treasury Index had a negative total return of 4.8%, while the S&P 500 Index gained 20.5%.

This reversal of fortune raises an interesting question for investors: Does it still make sense to maintain a portion of an investment portfolio in bonds? Many investors clearly have their doubts: From 1 June to 24 July 2013, net outflows from bond funds reached $76 billion, almost reversing $94 billion of net inflows during January to May 2013 (source: Investment Company Institute). Following are some of the core issues we at Gerstein Fisher look at when considering this important question.

Treasuries as a Volatility Hedge

As we see it, the purpose of bonds in an investment portfolio is not to generate high returns (the past 30 years of strong bond returns notwithstanding) but, rather, to dampen total portfolio volatility by balancing out such riskier holdings as equities and real estate. In particular, high-quality bonds like U.S. Treasuries generally help insulate a portfolio when stocks suddenly and unexpectedly plunge (notice that I do not include in this discussion high-yield bonds, which behave more like equities than like high-grade bonds).

A couple of extreme examples will illustrate this hedging phenomenon.  From 1 August 2000 to 30 September 2002, after the bursting of the tech bubble, the S&P 500 fell 41.3%. During that same time frame, short-term Treasuries (as measured by the Bank of America Merrill Lynch 1–3 Year U.S. Treasury Index) returned 18.3%, which was 10 points better than the Dow Jones Hedge Fund Index return. From 1 October 2007 to 28 February 2009, with the bursting of the housing bubble, stocks declined by 50.2%. While hedge funds shed 17%, short-term Treasuries gained 8.7%, a 26-point advantage. In other words, when the going got tough, Treasuries proved to be a more durable hedge than hedge funds. Thus, over time, investors who held Treasuries along with riskier assets experienced less of a drawdown at the total portfolio level during severe market downturns than did equity-only investors during those times.

To see what adding high-quality bonds (in this case, five-year Treasuries) to an all-stock portfolio does to portfolio volatility, consider the following: From 1 January 1975 to 31 July 2013, the worst three-year period for stocks was from 1 April 2000 to 31 March 2003, when the S&P 500 lost 16.1% annualized. Adding a 20% Treasuries allocation to the all-stock portfolio over this period would have cut that annualized loss by 5.1 percentage points, to 11%.

Liquidity and Investor Behavior

An allocation to bonds (and cash) in an investment portfolio also provides investors with more options if and when stocks decline. For instance, if you need income, you can liquidate the bonds rather than having to sell stocks at a loss.  If you’re a total-return-oriented investor who depends on your portfolio to meet living expenses, essentially you’re taking what the market gives you. You’re harvesting gains from equities in good times and from bonds during equities’ bad times. And if the stock prices drop to the point where they become a compelling buy, you have some money set aside to purchase shares at bargain prices and (potentially) make up some losses.

A related point: at Gerstein Fisher we generally discourage investors from keeping all of their bonds in a retirement account, even if this asset location strategy appears to be optimal from a tax standpoint. Most investors will at some point need the income from and liquidity of bonds, whether because of a bad market, loss of a job, or a large cash requirement, such as the down payment for a house or college tuition. This strategy can become a problem if all of the fixed-income assets are locked up in tax-deferred accounts while stocks reside in taxable accounts.

Another, perhaps subtler, role of bonds in a diversified portfolio involves investor behavior. We invest in equities because we expect to be compensated for the additional risk that they entail over lower-volatility assets, such as five-year U.S. Treasury notes. This equity risk premium was 4.7% from 1 January 1926 to 31 July 2013 (source: S&P Index Services). Investors will not realize this premium, however, if they panic and sell their equity holdings based on short-term, negative market events. We believe a healthy allocation to high-quality bonds will not only reduce overall portfolio volatility but also provide liquidity and peace of mind for the investor. This increases the odds that an investor will stay the course and remain rational in a turbulent stock market, thereby boosting the potential of long-term equity returns in the portfolio.

Reducing Duration

We don’t make interest rate forecasts, but it is of course quite possible that we’re only in the foothills of a long-term rise in interest rates. After all, rates are still abnormally low and would be expected to rise in a strengthening (and normalizing) economy. If you fear such a rise in rates, one way to reduce your exposure to this risk is to shorten the maturity or duration of your bond holdings from 10 or more years to 5 years or less (prices of most bonds have an inverse relationship with interest rates — when rates rise, bond prices fall; a shorter-duration bond will be less volatile); another way is to hold more cash. In fact, our research has demonstrated the improved return profile of holding short-duration, high-quality bonds during extended cycles of rising interest rates.

It’s a Big World

Finally, consider globalizing your bond portfolio. As with exposure to foreign equities, adding international bonds to a U.S.-centric portfolio potentially enhances the risk-adjusted return of the portfolio by reducing volatility and adding incremental return. We believe an allocation to foreign bonds deepens portfolio diversification across economies, currencies, and yield curves and can potentially help to hedge domestic inflation. For instance, the monetary and budgetary policies of Australia and Singapore are often totally unsynchronized with those of the United States, which can be a good thing from the standpoint of portfolio diversification.

Over the long term, currency returns historically have shown very low correlations with both U.S. equity and bond markets and are another source of potential portfolio return. We compared the hedged and unhedged returns of a foreign bond index (Citigroup World Government Bond Index Ex-U.S. 1–3 Years) from 1 January 1985 to 31 July 2013. The hedged return was 5.32% annualized, compared with 7.35% for the unhedged index. During the same time frame, similar U.S. bonds (BofA Merrill Lynch U.S. Treasury Index 1–3 Years) returned 5.65% annualized. The higher return of the unhedged portfolio did come with higher volatility but also with much lower correlation (0.32 vs. 0.61) with the U.S. Treasury index, which contributes substantially to portfolio diversification.

Conclusion

The risk of rising interest rates is real. But let’s not forget that high-quality bonds, we believe, are one of the best forms of protection against the unpredictability of stock market returns and play an important diversifying role in a portfolio. We can’t know what the markets will bring us next, so the most prudent course may be to ensure that your portfolio maintains good diversification protection against the possibility that another 2002 or 2008 happens.

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Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

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2 comments on “Bonds Still Deserve a Place in the Portfolio

  1. Pingback: CFA Institute 'Inside Investing' features "Why Bonds Still Make Sense," | Gerstein Fisher
  2. Pingback: Gerstein Fisher article on the role of bonds cited in U.S. News & World Report piece | Gerstein Fisher

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