“Should I be investing in bonds?” I hear this question a lot, given the economic environment we find ourselves in. It’s a great question. Since the early 1980s, we have seen bond yields fall substantially. With a few exceptions, the investing public’s experience has been bonds increasing in price. With all of the talk about inflation, whether it’s secular or transitory, and what it means for interest rates, it’s natural to question the whether it’s worthwhile to invest in bonds.
Two reasons to own bonds now (or any other time)
There’s almost never a bad time to own bonds. That’s a bold statement, I know, but it’s true. Bonds play an important role in portfolios. Here are two reasons why it’s important to hold bonds:
- Bonds are an important source of portfolio diversification. Over time, bonds have played in important role as a stabilizing factor in portfolios. Those sectors of the bond market represented in core benchmarks like the Bloomberg Barclays US Aggregate Bond Index — treasuries, investment grade corporate bonds and mortgage-backed securities — are the workhorses that, over time, have played an integral role in the traditional 60/40 portfolio (60% of assets invested in equity and 40% in bonds). High yield bonds and emerging market debt have seen larger price swings with greater sensitivity to equity volatility, yet even they can play an important role in diversification. No one likes to experience losses in their portfolio, but core bond exposure can be the ballast portfolios need when there are sell-offs in the equity market.
- The total return from bonds can still be positive. My colleague, Anthony DiOstillo, CFA, wrote a great piece on the current environment called “Rising Rates and Bond Markets: Keep Calm and Clip On.” In it, he highlights the secular decline in rates since the early 1980s and addresses the question of what could happen in a rising rate environment. At the end of 2001, the yield to worst of the Bloomberg Barclays US Aggregate Bond Index was a little more than 5%. According to Investopedia, yield to worst is “a measure of the lowest possible yield that can be received on a bond that fully operates within the terms of its contract without defaulting,”1 so it is a conservative measure.
What would happen if, over the next 20 years, yields on the Barclays US Aggregate Bond Index returned to that level? The picture below shows what that could look like. Bonds have two components: price return and the return from coupon payment, which is the interest you earn on your investment. While price return can be negative, we sometimes forget that coupons can be a dominant factor in our total returns from bonds.
We are always facing some degree of uncertainty and as investors, we make the best decisions we can, given what we know at the time. Rising rates are bad for bond prices but are positive for income from bonds, all else equal. Bonds have played an integral role in portfolios over time, and can continue to provide diversification and positive returns. If you are a financial advisor focused on helping your clients to achieve their financial goals, consider Anthony’s advice: keep calm and clip on.
1. “Yield to Worst (YTW),” James Chen, Investopedia, Investopedia.com.
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results.
This information should not be relied upon by the reader as research or investment advice and is intended for educational purposes only.
Information provided by SEI Investments Management Corporation, a wholly-owned subsidiary of SEI Investments Company.
Asset allocation may not protect against market risk.
Bonds are subject to interest rate risk and will decline in value as interest rates rise.
High yield bonds involve greater risks of default or downgrade and are more volatile than investment grade securities, due to the speculative nature of their investments.
Information provided by Independent Advisor Solutions by SEI, a strategic business unit of SEI Investments Company. The content is for educational purposes only and is not meant to provide investment advice or as a guarantee of any specific outcome. While SEI welcomes comments, SEI is not responsible for, and does not endorse, the opinions, advice, or recommendations posted by third parties. The opinions expressed in comments are the view(s) of the commenter(s), and do not represent the views of SEI or its affiliates. SEI reserves the right to remove any content posted by users of this site in its sole discretion.