You might have been looking at your fixed income investments (bonds and bond mutual funds) over the past couple of years and wondered why you’re invested in them at all. In 2013 and 2014, your returns on fixed income paled in comparison to the returns on your equities (stocks and stock mutual funds). Indeed, with the exception of the brief stock market corrections of the past month and in 2011, the performance of stocks has outpaced bond performance since 2009 by a large margin.
What’s been happening to fixed income performance in recent years? First, interest rates have been at historic lows since the Great Recession began in 2008-09. When interest rates are low, fixed income investments yield relatively little current income. After inflation, for example, the current yield on the 10-year Treasury is not much above zero.
In addition, fixed income security prices move inversely to interest rates. When interest rates are at historic lows, bond prices are about as high as they can be. So we can’t expect these securities to appreciate in value either. In fact, when the Fed ultimately raises interest rates there will be immediate downward pressure on bond prices. The short-term outlook for fixed income is therefore likely to get worse before it gets better.
What might a decline in fixed income investments look like? Almost certainly not like a bear market in stocks. Stock bear markets happen cyclically, and by definition mark a 20% or more decline in overall market prices. By comparison, a 1% rise in interest rates would likely result in a decline of about 6% or less for high quality, low and intermediate duration bonds – the type we typically invest in.
So why do we invest in bonds when the appreciation potential of stocks is so much higher? High quality fixed income investments stabilize a portfolio, precisely because they are less volatile than stocks. This can be very important if stock bear markets are steep. For example, during the 2008-09 bear market, portfolios that had a significant allocation to bonds (say 30-50%) recovered, on average, much faster than all-stock portfolios.
Additionally, fixed income prices and stock prices often move in opposite directions at any given time (negative correlation). In a typical economic cycle, an improving economy eventually results in the Fed increasing interest rates to combat rising inflation, causing bond prices to drop while the stock market usually continues upward. Then comes a recession, often triggered by those same rising interest rates. The stock market turns bearish and the Fed, to stimulate the faltering economy, reverses course and lowers interest rates – and bond prices recover. This process of negative correlation between equities and fixed income serves to reduce the volatility in a well-diversified portfolio.
Additionally, in recent years the stock market itself has become ever more sensitive to interest rate movements, often anticipating a recession at the first hint of a rise in interest rates. While this undercuts the process of negative correlation, it also puts additional pressure on the Fed to keep interest rates low, thus continuing to prop up the bond market.
A bond, by definition, represents a debt of the issuer and the debts of a company must be satisfied before stockholders of the same company can earn their return. Hence bonds are inherently less risky than stocks.
So you might not want to rush to offload your fixed income. High quality bonds and bond funds play an important role in reducing your investment risk and the volatility of your portfolio. Of course, if you have questions, don’t hesitate to reach out to us. We’re here whenever you need us.
**Past performance does not guarantee future results.