It has been easy for stock investors to love bonds as they have generated handsome returns while providing protection when the stock market falls.
Until recently, bond and stock prices have generally moved in opposite directions when stocks falter. But something different happened in September, and it could render bonds a weaker tool for portfolio diversification.
On Sept. 9, when the stock market fell 2.45 percent in a single day, the bond market did not follow its traditional script. Instead of rallying, the average core bond portfolio tracked by Morningstar dipped 0.34 percent that day. The one-day loss for many funds, including Vanguard Total Bond Market, iShares Core U.S. Aggregate Bond, Pimco Total Return and Metropolitan West Total Return, while less than a half a percentage point, still amounted to more than 10 percent of their current yield.
In itself, a loss like that isn’t going to upend anyone’s retirement plan, but it doesn’t merely portend declining long-term returns for bonds: It could also reduce the buffering effect of bonds in a portfolio that contains stocks.
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Jeffrey Knight, co-head of Global Asset Allocation at Columbia Threadneedle, says that problem is likely to continue in the future. In his view, what happened on Sept. 9 is “exhibit A” for what he expects to play out when central banks start to tap the brakes on their aggressive policies to stimulate economic growth.
“Both stock and bond values have been driven up by monetary policy, and as we approach an inflection point where that policy changes, they both have the same reason to sell off,” Mr. Knight said.
We may indeed be closer to that inflection point. While the Federal Reserve chose to leave short-term interest rates unchanged at its September meeting, the latest odds put a very high probability on a December increase. In the meantime, the yield of the 10-year Treasury rate has quietly inched up from below 1.4 percent in early July to 1.7 percent. That is still well below the 2.25 percent at the beginning of the year, but it signals that a shift may be underway.
James Paulsen, chief investment strategist at Wells Capital Management, is mindful that previous rate increases in the bond market have quickly reversed themselves, but he says that this time may really be different. Without the Federal Reserve’s intervention, Mr. Paulsen says, the 10-year Treasury yield would be in the vicinity of 4 percent based on current levels of economic growth, core inflation and wage growth. “I am not suggesting we are headed there this year,” he said. “But if this recovery persists, and the Fed takes its peg off, I would not be at all surprised to see us around 4 percent before the next recession.”
If that were to play out, rising yields would mean bond prices would fall. Total return is the sum of yield and changes in bond prices. Today’s razor-thin yields of around 2 percent for quality bond funds suggest that initial total returns will probably be negative, though over time patient investors will benefit from the reinvestment of higher yields.
The challenge is to anticipate today how you might react to a less rosy performance for bonds — which have returned 4 percent annualized over the last 15 years — and make any necessary portfolio tweaks. “Diversification still works, but the way to think about it is that the cost of diversification has gone up,” says Richard Turnill, global chief investment strategist at BlackRock. Because bonds don’t have much room to rally at current price and yield levels, they may merely hold steady, or potentially lose a little when stocks falter.
The implications are worth considering. It could mean slightly larger bear market losses for diversified stock and bond portfolios. In 2008, for example, when United States stocks fell 37 percent, high-quality core bonds rallied more than 5 percent. An investor with a standard, index-based portfolio containing 60 percent stocks and 40 percent bonds lost about 20 percent that year. But bonds rallied while stocks fell. If bonds hadn’t risen in value but instead had lost 2 percent, the portfolio would have lost 23 percent.
While not cheery news, that’s not an end-of-days prospect. Core bond funds that invest in high-quality United States securities may not produce world-beating returns, but they are not likely to lose much, either. One important aspect of core bond funds — their relatively short 5.5-year average duration — should prevent big losses. Duration is a measure of a bond portfolio’s sensitivity to changing interest rates. A one percentage point rise in a portfolio’s yield typically causes the price to fall in line with its duration. That translates to a 5.5 percent price decline for a core bond fund with a 5.5-year duration if rates were to rise one percentage point.
In the spirit of hypothetical stress testing, Vanguard crunched the numbers for what would be a highly unlikely event: an abrupt three percentage point increase in the yield of the Barclays U.S. Aggregate index from its current very low 1.95 percent. The index has a current duration of 5.5 years. That increase would produce a return of negative 13.1 percent in the first year. If rates stabilized after that move, the cumulative loss by the end of the second year would be 8.75 percent. Returns would be back above break even in Year 4 thanks to the reinvestment of the much higher yield.
How bad would that be? It depends on your perspective. “In a horrible, truly worst-case scenario, a high-quality bond index fund is still less risky over the course of a year than stocks are in one day,” says the investment adviser Allan Roth, founder of Wealth Logic in Colorado Springs, alluding to the 20 percent decline in the Standard & Poor’s 500-stock index on Oct. 19, 1987.
A well-honed actively managed bond fund might mitigate a portfolio’s sensitivity to rising rates.
For example, right now bond index funds that closely mirror the Barclays U.S. Aggregate index are loaded with Treasury and government agency bonds. Those are what you want when markets falter, but they have extremely low yields today and typically are very sensitive to rising rates. By comparison, the Baird Core Plus Bond has the freedom to decide on its bond mix.
“Trying to hit a lot of singles, and not swing for home runs” as the fund’s co-manager, Mary Ellen Stanek, describes the strategy, has delivered index-beating performance since the fund’s 2000 inception. The fund also ranks in the top quartile of its peers over the last one-, three-, five- and 10-year periods. Currently, the fund’s Treasury stake is much lower than what is stuffed in its benchmark index, and it owns a lot more American corporate bonds. On average, high-quality corporate bonds currently have yields that are at least one percentage point higher than Treasury bonds. “We think we’re in the seventh inning for corporate bonds. The fundamentals look pretty good,” says Warren Pierson, also a co-manager.
Another option, and a conservative one, is to move some of your money out of bonds and into cash. Even investment strategists — a tribe always at the ready with the best relative values in stocks and bonds — acknowledge the “optionality” value of cash these days, which is an obtuse way of saying it makes sense to have some money on the sidelines ready to get back in the game after sell-offs. “The opportunity cost in the short run is low,” says Mr. Turnill, the BlackRock strategist.
Mr. Roth, the Wealth Logic founder, has made five-year certificates of deposit the centerpiece of his clients’ fixed-income portfolios. For example, the current 1.75 percent yield offered on deposits of at least $25,000 by Ally Bank is nearly on par with the 1.95 percent yield of the Barclays Aggregate bond index. Even in the event of paying the penalty for an early withdrawal, the effective yield would be more than 1 percent. “We have no principal risk, and our money is 100 percent government guaranteed,” says Mr. Roth. (If you’re looking to remove some rate risk from your 401(k) portfolio, check if there is a so-called stable value fund in your plan; the average current yield is 1.8 percent, according to Hueler Analytics.)
Of course, cash is a market timing call, and market timing is not easy to do properly. What’s more, cash or liquid investments like money market funds or short-term CDs aren’t likely to keep pace with inflation in the long run. But if you become deeply worried about bonds and stocks, cash is not the worst place to wait out a shifting market.