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Believe In Bonds

by Evan C. LeRoy, Portfolio Manager Analyst 

With 10-year Treasury yields near historic lows (See Chart, 2.50% at the end of October 2013), investors are questioning how the asset class fits into their overall portfolio. As bond yields increase, bond prices are inversely related and thus prices decrease. Individual bonds pay the investor a semiannual interest payment until maturity or some other event when the initial investment is repaid, in addition to accrued interest. So why hold an asset that is certain to lose value if yields increase when the Federal Reserve’s Quantitative Easing (QE) program ends?

Our outlook on bond returns over the next few years is for low to negative returns, which may look like a risky bet. Homeowners insurance is a great analogy for why investors should continue to allocate part of their portfolio to fixed income. After all, homeowner’s insurance premiums never earn a rate of return! Yet we buy the insurance in the event of some catastrophic event like a flood, tornado or fire and trust that the insurance company will pay our claim when we need it the most. One of the reasons portfolios include bonds is disaster protection.

While bonds can provide steady income flows, they have also been a reliable portfolio diversifier, with negative correlation to the equity markets. When stocks perform poorly, bonds tend to outperform and vice versa. Some investors have increased the risk of their portfolio in search of higher yield. Take high yield bonds for instance, not only do these higher yielding assets tend to be more correlated with the equity markets, but they also add more risk to the overall portfolio.

Before abandoning bonds entirely, consider the risks of bonds and equities and the potential magnitude of loss in each. According to Vanguard research, in the rolling 12-month periods from 1926 to 2011, there were 211 instances when equities saw returns fall by 5% or more, but only 30 instances when bonds had losses of 5% or more! So the moral of the story? Bonds reduce volatility (a measure of risk) and smooth returns over the long term.

Bonds strategic long term value in most portfolios has not changed, despite possible low or negative total return prospects over the next few years. The fixed income asset class has as many or more unique sub asset classes than equities. International, emerging debt (local currency, dollar denominated), floating rate, sovereign debt, municipal (state specific and national), mortgage backed securities (MBS) and non-agency MBS are just a few areas within bonds. Some of these sub asset classes will perform better than others in a rising interest rate environment. Rest assured, the United Bank & Trust Wealth Management Group has strategies in place for managing our clients’ portfolios through these dynamic markets.