3 Roles Bonds Can Play In A Portfolio
As many investors know, bond investing is not easy. In a previous blog post, I had briefly touched upon how to sidestep the most commonly made mistakes. Today, I want to dig more into the first of the three mistakes – forgetting what your fixed income investment is for.
Why do investors own bonds anyway? After all, we know bonds generally offer lower returns than stocks over time. Investors I talk to point to three things:
1. Diversify equity risk
The logic behind diversification is that most investments don’t move together in the same direction at the same time. If an investor holds different types of investments, their gains and losses can potentially offset each other and make the investment experience smoother. If you take the S&P 500 to represent the stock market and the Bloomberg Barclays Aggregate U.S. Bond Index for the bond market, it’s easy to see that stocks and bonds haven’t tended to move in lockstep. Their correlation over the past 10 years is 0.03 – close to zero – meaning stocks and bonds have generally gone their own ways (source: Bloomberg data using monthly returns, as of 7/31/2017). And, that can be a good thing, because it’s less likely that stocks and bonds in a portfolio have both gone down in price at the same time.
Investors can clearly see diversification in action when equity markets are down, and bond investments are there to potentially provide stability to the portfolio. Historically, when stocks fall, money often moves from stocks to bonds – so called “flight to quality” – pushing bond prices up. Prices tend to go up more for bonds with higher levels of interest rate risk. For this reason, fixed income investments that have medium to high levels of interest rate risk may provide better diversification to equities than investments with lower levels of interest rate risk. This is a very important point, and one that is often missed by investors: If you hold bonds to diversify equity risk, interest rate risk is key.
2. Generate income
Income is a bit of an easier one. Most bonds and bond funds pay income on a regular basis, and many investors look for income from their bond portfolio. As a rule of thumb, bonds that carry higher levels of risk pay higher levels of income. The two most common forms of risk in fixed income markets are interest rate risk and credit risk, and most bond investments carry one or both of these risks. A quick rundown: Short-term Treasuries have very little credit risk and interest rate risk, and as a result, they pay a low level of income. An intermediate bond with a medium level of credit and interest rate risk generally pays a higher level of income. A high yield bond may only have medium interest rate risk, but its high credit risk could mean high income. Remember, there is no free lunch here. To seek income, investors have to be willing to take on risk.
3. Preserve principal
Investors who want to use bonds to help preserve the principal of their investments do not want to see prices drop under any market conditions. The prices of short-term Treasuries such as T-bills have historically been more stable than many other stock and bond investments, as a result, they tend to be a popular choice for preserving principal. T-bills have low levels of both interest rate risk and credit risk. In fact, when thinking about principal preservation, it is most important to keep both types of risk in mind. Don’t become preoccupied with one and forget about the other. Consider this scenario: An investor is looking for an investment that preserves principal but still hopes for some income from their investment. Bank loans might offer a high yield and stand out from a list of potential low interest rate choices. The problem? Bank loans are often similar to high yield bonds in that they can carry a high level of credit risk. While they may fare well in a rising rate environment, they would likely fall in price should there be a credit event. Investing in bank loans probably won’t help investors preserve principal.
Mix and match
Now that we have covered each of the three objectives in more detail, here is the hard part: Many investors want their portfolios to do more than one thing, but these objectives are not always compatible with each other. A simple way to think about this is in terms of risk. Diversification and income lend themselves to risk taking, while preserving principal does not. As a result, some combinations might work better than others.
Bond investing goals
Income and diversification
A number of medium- to longer-term maturity investments may work in this scenario. Taking on interest rate risk could provide income and improve diversification. Investors may also want to add credit risk to seek more income potential.
Income and principal
Things are a little more challenging with this combination. In today’s market, it’s nearly impossible to generate income and preserve principal at the same time. Short maturity T-bills yield just over 1%, and that isn’t much income (source: Bloomberg as of 7/31/2017). For most income targets, investors would need to consider taking on some interest rate or credit risk, which could put the principal at risk. Of course, this was not always the case. During periods when interest rates were higher, it was possible to get a modest amount of income without taking on a lot of risk. But not today.
Diversification and principal
These objectives just don’t go well together. As discussed above, the key to a bond investment that helps to diversify equity investments is interest rate risk. And, taking on interest rate risk increases the chance of loss of principal if interest rates rise. This combination is more difficult to achieve.
Today’s low return environment can make it challenging for bonds to achieve any one of the diversification, income, and principal goals, not to mention a combination of them at the same time. More than ever, it makes sense to hold realistic expectations. Be mindful and precise with what you want your fixed income investment to do. Remember your bond investing goal.