Why Bonds Still Make Sense in a Portfolio

Volatility in the markets is nothing new. However, it’s fair to say that this year has been exceptional with both equities and fixed income posting negative returns. In fact, since 1926 there have been only four times in which both major asset classes posted negative returns for the same full calendar year. The situation has left some investors questioning whether fixed income still warrants a place in a portfolio. Our simple answer is “Yes.”  Historically, bonds have served three purposes in a portfolio; as a diversifier to equities, to provide safety of principle, and to generate income. We view the current challenging backdrop as an unpleasant but rare occurrence as opposed to a fundamental change in what has historically served as a sound financial approach.

Putting bonds’ recent performance in perspective

As of the end of November, bonds as measured by the Bloomberg U.S. Aggregate Bond Index were down 12.6 percent, making this a year for the record books. While the year is not over, 2022 is on pace to eclipse the 2.9 percent drawdown of 1994, which currently stands as the worst calendar year performance in the 46-year history of the index. For further context, since 1976, there have only been four total years where fixed income finished the year negative. The average return for bonds during those years was a loss of about 2 percent.

Bonds are still an important source of diversification

So why has this year witnessed such unusual performance? The common thread among three of the four years that bonds and equities declined in tandem (1931 being the exception) is that they coincided with periods of elevated inflation of 5 percent or more. Clearly this year fits the pattern, however we believe inflation will subside in 2023 and beyond. As inflation begins to wane, the relationship between bonds and the stock market should normalize and fixed income should once again provide the ballast that is critical to portfolio construction. Case in point, when looking at years where the stock market ended down for the year, the average return for bonds in those years was 5.5 percent compared to the average stock market loss of 13 percent.

Bonds tend to provide all weather performance

While some investors have become skittish about owning bonds during rising rate environments, history suggests those concerns may be misguided. In the short term, rising interest rates can cause weakness in bonds; however, this is not necessarily a negative for longer-term investors. Historically, almost 90 percent of a bond’s total return comes from the income generated from coupon payments. Because of this, forward returns tend to follow the path of interest rates, highlighting the fact that investors can benefit from the stability and income that bonds bring to a diversified portfolio in all interest rate environments. 

The value of managing risk with bonds over chasing yield with equities

In addition to prompting some to consider selling out of bonds altogether, the recent rise in rates and yield-curve inversion has led others to consider swapping out of longer-duration fixed income in favor of marginally higher yielding short-term Treasurys. While reallocating to the short end of the yield curve may seem appealing, we would caution that timing movements in rates is risky and near impossible to do successfully over long periods of time. While it is true that the relationship between interest rates and bond prices have an inverse relationship, this phenomenon is more focused in the short-term and investors with a longer timeframe historically have benefitted from the modestly longer duration that is associated with an intermediate bond portfolio. Since 1954, the average return on intermediate government bonds as represented by the Ibbotson Associates SBBI U.S. Intermediate-Term Government Bond Index over any five-year rolling period was 6.1 percent. During that same timeframe, 1-year bonds and T-Bills returned 5 percent and 4.4 percent respectively. This included both rising rate environments (1954 – 1981) and declining rate environments (1981 – 2021). While the recent rise in interest rates might make the short-end of the yield curve a tempting proposition, it is important to remember that successful investing involves looking forward not backward. Having a core bond portfolio consisting of high credit quality, intermediate duration fixed income can offer longer-term investors some confidence by investing in bonds which are positioned to work well in rising and falling interest rate environments.

Ultimately, like any investment, your time in the market is more important than timing the market. In fact, as you can see below, since 1926 there have only been six prolonged drawdowns of 5 percent or more, with the average lasting a little more than a year. Conversely, the average bond market expansion has lasted more than 15 years producing 163 percent in gains.

It’s easy to focus on performance and have a narrow view on particular asset classes but that approach carries risk for investors. Diversification is key and may be critical as we look ahead more than ever. A smart investment strategy leads with a steady outlook and looks through an objective lens that incorporates valuations, considers where we are at in the economic cycle, the forward path of monetary and fiscal policy, and market structure.

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 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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