Why Bonds Still Belong in a Portfolio
It’s no secret that the bond market hasn’t exactly been a cash cow lately. And while bond yields have been historically low for years, the past several weeks have seen the yield on the 10-year Treasury bond fall below 1 percent for the first time ever. That’s led many to question whether bonds are still a good investment.
We sat down with Mike Helmuth, Chief Fixed Income Portfolio Manager, Northwestern Mutual Wealth Management, to talk about the role that bonds play in an investment strategy and how you should respond to record low yields.
Why should I buy bonds right now if I can just earn as much or more in a money market account?
People ask this question often, but as bond yields have fallen, we have been getting it more frequently. We believe it’s important to have bonds in a portfolio because they generate income and are less correlated with equities, for example. A money market account, while stable, doesn’t behave like a bond. The interest rate that a money market account pays will typically rise and fall as the Federal Reserve moves its rate, but the face value of your money market account won’t generally change. Choosing a money market account over bonds is essentially a directional bet on the Fed’s interest rate policy. Bonds, however, offer a little more in a portfolio. While bond yields are sensitive to the Fed’s interest rate policies (and other factors), the face value of a bond rises as the yield falls. Conversely, as the face value of a bond falls, its yield rises. In other words, often in times like these when yields are falling the increase in bond values can ballast a person’s overall portfolio.
Should I sell my bonds now? Do they still make sense?
As a firm, we believe long-term financial planning balances growth with risk management. That means building a diversified portfolio of assets that aren’t always correlated, which tends to smooth the impact of market volatility over a targeted time horizon. In other words, the price and volatility of any given asset shouldn’t inherently alter the plan, outside of proper rebalancing to reflect a person’s risk tolerance. More broadly, that’s why financial plans include diversified exposure to equities and bonds, but also cash value life insurance, real estate, annuities and other assets that have different characteristics, but complement one another. Bonds are simply one building block of your diversified portfolio, which means we think they always have a place in a portfolio.
Still, bonds are set up to lose money now right?
Maybe. Maybe not. But you can say that about any asset class at any time.
The reason bonds are getting more attention than other asset classes right now is that their yields are so low, and investors think they won’t earn anything on their money. While yields have fallen, a bond with a 1 percent yield can rise or fall 3 to 5 percent just as likely as a bond with a 10 percent yield. The reason people say bond yields are “low” is because they used to be higher. However, that fact hasn’t stopped bonds from doing their jobs in a portfolio: provide solid performance and serve as a ballast in choppy markets. Again, the bigger picture is that price and yield fluctuations in any single asset shouldn’t impact the overall objectives of your long-term financial plan.
Why would I invest in something that yields close to zero?
We’ve been thinking about this question for many years now as rates have fallen. Some developed countries are even issuing bonds with negative yields, so this question is already front of mind for them.
The answer isn’t simple, but I’ll try to make it simple. Even though a bond yields next to nothing, there’s still a need for safer assets. People holding bonds with negative yields believe the “cost” of holding them is still safer than the potential for loss in riskier assets. Even with negative yields, there obviously are investors who need safer assets in a broader plan, even with very low expected returns.
What are fixed income portfolio managers doing differently today?
The instinct is to increase yield in a portfolio, which usually means adding more credit risk (higher risk, higher return/yield). We don’t advise this, because dramatically lower rates can mean interest expense continues to fall and is a tailwind for companies, or interest expense needs to be this low to maintain stability in the economy. It is yet to be seen how low rates will impact the broader economy. In flight-to-quality situations like we are seeing, spreads are widening between risk free and riskier assets. There are opportunities there in front of us, but not currently.
Therefore, we keep it simple and stick to the proper credit risk for a client’s given level of risk tolerance. If you haven’t noticed a theme it’s this: Stick to the plan. You’re in this for the long term and that commitment doesn’t change, no matter what the stock or bond market does.
Please remember that all investments, including bonds, pose some level of risk, including loss of principal invested. Commentary is written to give you an overview of recent market and economic conditions, but it is only our opinion at a point in time, is subject to change, and shouldn’t be used as a source to make investment decisions or to try to predict future market performance. To learn more, click here.
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