Stocks routinely receive all the attention from the media and investors. They’re often portrayed as sexy and fun, while bonds are often portrayed as stale and boring. You can easily find stories about people becoming rich investing in stocks. You never hear about anyone bragging about becoming rich investing in bonds.
Yet you might be surprised to learn that the size of the global bond markets is actually much larger than global stock markets. The value of global stocks is roughly $95 trillion,1 with U.S. markets accounting for roughly $50 trillion of that value (with U.S. stocks near record highs).2 Meanwhile, the value of global bonds is roughly $128 trillion.3
Core bonds have generally been used in portfolios to help dampen overall portfolio volatility (i.e., bonds provide a cushion to stock market volatility) while providing some current income.
With U.S. 10-year Treasury yields (the interest paid to the bond holder) recently setting record lows, some investors are questioning whether bonds still have a role in portfolios. The media and investors often raise these concerns within two interrelated threads:
- Bond yields are so low that they don’t provide meaningful returns
- As interest rates presumably rise back to a normal historical range in the future as the economy normalizes, the price of bonds could fall, leading to losses
The role and benefits of bonds
To address these concerns, you must fully understand the role of bonds in a portfolio. Bonds are NOT included in a portfolio of stocks and bonds to generate maximum portfolio returns. That’s the job for stocks. However, the problem for most investors is that the maximum returns that stocks can provide also means they have to live with maximum volatility. Most investors simply can’t stomach the volatility of a 100% stock portfolio, which often results in poor investor behavior such as getting scared out of the markets when large corrections occur.
High-quality bonds, on the other hand, have little volatility compared to stocks and generally offer steady returns. Think of stocks as the gas pedal in a car, while bonds are the brakes and shock absorbers. You will get to your destination much faster with just the gas pedal in a car, but it will be a much smoother emotional ride if you also have brakes and shock absorbers.
Like stocks, bonds can suffer occasional temporary losses, but bond losses tend to be significantly less than stocks. For example, the S&P 500 suffered a loss of about 50% in the 2007-2009 financial crises, while the worst loss for bonds over the last 40 years was in 1994 when the Barclays U.S. Aggregate Index (an index of investment grade U.S. taxable bonds) lost 2.9%.4
Bond prices generally move inversely to interest rates. This means that when interest rates rise, bond prices generally fall, resulting in losses. We have seen this play out this year so far as bond yields have risen off of their historic lows, resulting in losses in the Barclays U.S. Aggregate Index of 2.6%.5 This is the reason why bonds are receiving some extra negative attention at the moment.
Of course, it should be noted that trying to predict the direction and timing interest rate moves is as difficult as trying to predict short-term stock market moves (although that doesn’t keep lots of “experts” from trying).
On the other hand, rising interest rates also portend higher yields and returns on bond portfolios going forward. As the chart below reflects, if interest rates increase by 1%, bond investors should be rewarded for their patience with higher returns in the future. Selling bonds after a period of rising yields is akin to selling stocks after a significant market decline.
Recent bond performance history in a similar environment
It’s expected that the Federal Reserve will keep short-term interest rates near zero for the next two years and possibly longer.6 In the aftermath of the great financial crisis, from 2009-2015 the Federal Reserve held the federal funds rate near zero. Over that same time period, the Barclays U.S. Aggregate Index returned 4.1% per year.7 Inflation over that same time period was 1.7% per year.8 Thus, the return of investment-grade bonds beat inflation even through that past period of low yields.
It’s also not a given that all bond prices will fall when the Fed raises interest rates. Supply and demand dictate the prices of bonds at various maturities. In the most recent period of Federal Reserve rate increases from December 2015-June 2018, the Federal Reserve increased rates 1.75%. High-quality intermediate term bonds gained 3.33%, and municipal bonds gained 2.17% during that period.9
Possible alternatives to bonds
If you believe bonds will provide an unsatisfying return in the near term, what are the alternatives to bonds? Let’s look at each of them:
- Cash: Cash reduces the risk of a potential short-term loss in bonds as interest rates potentially rise, but the expected return is even less than bonds. As stated above, the recent history of bond returns with very low interest rates in 2009-2015 suggests this isn’t an attractive alternative when cash is earning almost no return.
- More stocks: Adding to your stock allocation might work to produce higher returns, but it also increases your risk in the short term. Can you stomach the volatility that comes with a higher allocation to stocks? Recall that stocks can drop by 50% or more, while the worst bond loss in the last 40 years was 2.9%. Slightly increasing your allocation to a globally diversified portfolio of stocks may be an option if you are comfortable with increasing your risk of short-term volatility and loss compared to sticking with an allocation to bonds.
- Alternative funds: After the 2008 financial crisis, we witnessed an increase in expensive liquid alternative funds that were marketed to provide a hedge against a 2008-like market event. Fast forward 10+ years, and the evidence shows that most investors would have fared better with a high-quality, well-diversified bond allocation.10
While the short-term view of bonds may be unsatisfying to some, in most cases the alternatives could create worse outcomes.
There are times when investors need to recognize that the short term may be slightly rocky for an asset class and have some patience. Bond portfolios will likely eventually benefit from rising interest rates, and in such event, bond investors will be rewarded for their patience.
In the meantime, bonds should continue to do their job in the portfolio by providing a smoother overall experience for investors and their portfolios than the alternatives on a risk-adjusted basis.