- Accordingly, it’s not surprising that investors are thinking about the risk of meaningfully higher interest rates and, as a result, falling bond prices.
- We believe core, investment-grade bonds have a role in a diversified portfolio regardless of market conditions.
Why own bonds?
With interest rates still at historically low levels, some investors are asking whether there is still a role for core, investment-grade bonds in a diversified portfolio. We believe there is. First, bonds can provide meaningful income generation. While the current income received from bonds is quite low compared to history, we believe the relationship to cash and implied returns on riskier assets are within reason as compared to those of the last 25 years.
With no other consideration than the comparison of current yield levels to historical averages, an investor might conclude that core bonds are overvalued. However, just because core bond yields are at historic lows, they aren’t necessarily overvalued owing to where the yields on other asset classes sit (the opportunity cost). An investor who desires greater income might have to take on additional risk/duration/illiquidity. As with any portfolio repositioning, the change in exposure comes with tradeoffs that should be balanced with other goals and objectives. In other words, we think that the current level of
core bond yields can be justified given everything else in the current state of
Additionally, bonds still provide valuable diversification benefits. Because the returns on high-quality bonds tend to behave differently than the returns on riskier, growth-oriented assets like stocks, they can help lower the volatility of an overall portfolio. In other words, in a diversified investment portfolio, some assets should rise when other assets fall—which is often what happens in the relationship between stock and investment-grade bonds.
A multi-decade tailwind
A nearly four-decade-long downtrend in global interest rates, as shown in Exhibit 1 (download the full commentary to see exhibits), provided a longstanding boost to bond returns. The broad downtrend in global rates continued into mid-2020, falling to record lows in many countries as the global pandemic took hold. Interest rates have since moved higher, thanks to the stronger growth and inflation outlooks fostered by forceful policy measures and the arrival of effective vaccines. Thus, the more interesting (and perhaps pressing) question is how serious the risk of higher interest rates is to future returns on investors’ bond holdings.
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