The Balancing Act of Bonds

Author: Martin X. Shields, CFP

For most investors, bonds play an important role in their portfolio of providing income and capital preservation in times of volatility. For the past 40 years, having a bond allocation in a portfolio has been very beneficial because the U.S. 10-year Treasury rate has declined from a high of more than 15% to last year’s low of 0.6% – as shown in Exhibit 1 below.  Since there is an inverse relationship between interest rates and bonds this decline has been a huge tailwind to support rising bond prices and boosting their annual return.

 

Key Takeaways:

1. Over the past 40 years, bonds have been a reliable investment.
2. As interest rates start to rise from historical lows, bond values are dropping.
3. Looking forward, investors face a balancing act to keep some allocation to bonds because we live in a world of global risk and bonds play a role in times of volatility.

 

Exhibit 1

(Source: JP Morgan)

 

Interest Rates at Historic Lows

Now that interest rates are at a historical low point, the likelihood of rates rising over the next couple of years is fairly high.  These rising rates will cause bond prices to decline which is what investors have experienced YTD with stocks showing a positive return and bonds down for the year. Exhibit 2 below shows how bonds are impacted by a 1% rise in interest rates.  As shown, the longer the maturity the greater the decline in the value of the bond.

 

Exhibit 2

(Source: JP Morgan)

 

Bond Balancing Act

The balancing act that many investors need to take is to keep some allocation to bonds because we live in a world of global risk and bonds play a role in times of volatility.  With that said, there are other asset classes and investment options that will help mitigate this interest rate risk while not distorting the overall risk in your portfolio risk. Two funds we have implemented for parts of our clients’ bond allocation in tax-deferred accounts are hedged equity and broad-based commodities. These are diversifying assets that will protect against inflation concerns and rising interest rates.

 

If you have any questions regarding ways to manage this risk in your portfolio, please feel free to contact our team for a discussion.