Thankful investors, don’t overlook bonds
It’s too early to put a bow on what has been an encouraging year for investors, but in the spirit of the season, there is much to be thankful for.
Synchronous economic expansion has given rise to double-digit returns in global stock markets. Rising asset prices – in both stocks and housing – have boosted investor confidence, which has been further supported by strong corporate earnings and forecasts for continued growth.
Lost in the stock market euphoria, though, many investors are overlooking a good year for bonds. Short-term, higher quality bond funds are up 2% to 3% so far this year, while many intermediate-term bond funds are up 3% or more.
Although 2% to 3% may not seem like a lot in the face of double-digit stock returns, bonds have contributed meaningfully to investment portfolios in 2017. Earlier expectations called for only modest bond returns, amid forecasts of higher interest rates and an uptick in inflation. So far, though, inflation remains in check, and interest rates have risen on bonds of only the shortest maturities.
Reaching for yield, investors have heightened demand for the interest premium paid on bonds with lower credit quality. As a result, so-called junk bonds have fared significantly better than higher quality bonds so far this year.
In the face of strong returns from both the stock market and lower quality bonds, as well as the likelihood of continued Federal Reserve increases in the overnight lending rate, many investors are losing sight of the roles that higher quality bonds should play in a portfolio. Here is a reminder:
- Bonds can provide a steady stream of income. That income may be relatively low, given where interest rates are, but it is still positive considering the low level of inflation.
- Bond prices are typically less volatile than stock prices, which makes bonds a great source of portfolio withdrawals. Stocks do more than just go up. When they go down, a healthy allocation to bonds reduces the risk of needing to sell stocks (at lower prices) to cover retirement expenses.
- Perhaps the most important feature of bonds is the benefit they have on diversification. The price movement of high-quality bonds is largely unrelated to the price movement of stocks and other investments. By placing uncorrelated assets like stocks and bonds in a portfolio, we can reduce risk, often without meaningfully shifting the potential for returns.
With the right bonds and in the right dosage, investors can position themselves for an uncertain future without a major sacrifice in return. But bonds also face risks.
For instance, an uptick in inflation could cause the Fed to more aggressively raise interest rates. Rising rates would put downward pressure on bond prices in the near-term but in the long run offer increased income from higher interest rates.
Bonds in the short to intermediate range appear best positioned to take advantage of any rate change. Bonds with a long maturity will take some time to mature and be reinvested at higher rates while bonds with too short of a maturity may not see a large enough increase in interest rates.
Another risk is investing too much in the wrong kind of bonds – specifically, higher yielding, lower quality junk bonds. Junk bonds offer a yield premium for their lower quality. However, as a narrowing credit spread suggests, the premium may no longer be wide enough to compensate investors for the increased risk.
In addition, junk bond prices tend to move more like stocks than bonds. When, eventually, we see a stock market correction and stock prices decline, the narrow yield premium from junk bonds wouldn’t be much comfort for money that should have been in safer alternatives.
Bonds play important roles in a portfolio – reducing risk and diversifying returns. That may be overshadowed by the gains of stocks as we head toward the end of 2017. Still, bond performance has been a blessing for which investors should remain thankful.
Kyle Tetting is director of research and an investment advisor at Landaas & Company.
(initially posted Nov. 21, 2017)