It’s no secret that bonds haven’t exactly been fun to watch lately. Rising interest rates and inflation have taken a bite out of most fixed income portfolios, and most investors are not accustomed to seeing that. That’s because we’ve just come out of a 40-year bull market for bonds – the longest in history.
The Role of Bonds in Your Portfolio
Bonds (fixed income) are the ballast of your portfolio. They have historically provided stability and diversification to an equity portfolio. And, when combined, can provide an optimal risk adjusted return depending on one’s long-term financial goals.
Even in this tough environment, we don’t think the fundamental role for bonds in your portfolio will change. Are we in for a more challenging period for fixed income than we’ve experienced over the last four decades? Most likely.
An Inverse Relationship
Interest rates and bond prices have an inverse relationship. As rates go up, bond prices go down – and vice versa. So, the overall performance for many bonds in a rising rate environment can suffer. This can be a difficult concept to grasp sometimes, as it is somewhat counterintuitive. You may be asking, “wouldn’t rising rates be good for bonds if I can go out and buy a bond with a higher yield, and thus receive more income?”
Let’s break this down with a simple example: A while back, Investor A bought a 10-year treasury bond with a coupon rate (the rate it pays) of 1%. Today, Investor B can buy a new 10-year treasury bond with a coupon of 1.5%. Obviously the new bond paying 1.5% is more desirable. Investor A now wants the new bond with a better rate, so he goes to sell his bond to upgrade to the new bond. But no one is going to buy his old bond paying 1% when they can buy a new one paying 1.5%. So, he has to sweeten the deal by selling at a discount. He’ll take a loss on the sale of his bond.
Imagine that example happening on a mass scale over millions of transactions. This is why rising rates can be detrimental to a bond portfolio and the fixed income universe in general. If rates continue to rise, it will make for a difficult environment for existing bonds, because those rates are “fixed.” By default their prices will have to come down.
Below is a 60-year history of the 10-Year Treasury rate:
You can see that there was a multi-decade period of rising rates up until around the end of 1980 – probably a tough slog for bond prices. Then we entered into a 40-year period of declining rates – the “greatest bull market for bonds in history.”
Over the last 18 months we’ve seen rates increase. And with the Fed announcing it will begin tapering (reducing bond purchases) soon, rate hikes could be in the cards in the future.
Will interest rates continue to go up for decades, like in the past? We simply don’t know. Every cycle is unique. And even if there is a long-term rise in rates, you will certainly have cyclical periods where rates decline and bond prices shine.
A reasonable assumption is that this could be a tricky and challenging time for fixed income investors.
Changes to Your Bond Portfolio
Of course bonds still have a place in your portfolio. In light of everything discussed we are taking a more active approach to our fixed income portfolios. I’m not at all suggesting we are going to start tactically moving in and out of sectors, or trying to time interest rate movements, etc. We are simply going to be including new active bond managers with more flexible investment mandates.
These new funds will have more flexibility with regard to duration (yield curve positioning), sector rotation, regions, and public / private debt, etc. We will still have plenty of exposure to “core bond” positions, but will be introducing more diversification into different sectors and regions.
We have also partnered with PIMCO, one of the largest bond managers in the world, to provide our clients access to an interval fund that invests in both public and private debt markets. Private debt is something new to the portfolio.
These changes will occur over the next couple of months. Your tax-deferred accounts will likely be reallocated first, then we will make our way through the taxable accounts. We will be taking into account each client’s taxable gain situation during implementation.
The level of change that occurs will depend on your current allocation and account type. If you do not have exposure to bonds, this will not impact your portfolio.
If you have any immediate questions, please reach out to your advisor for more information.
Thank you for your continued trust and confidence.