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Investment Insights: Why Do I Have Any Bonds In My portfolio?

October 11, 2021
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At the surface, this seems like a reasonable question, given that ten-year US Treasury bonds are currently yielding a paltry 1.5%.  At that level, bond yields are certainly not keeping up with inflation, especially this year.  Per the Bureau of Labor Statistics, The Consumer Price Index for All Urban Consumers (CPI-U) increased 5.3% over the twelve months leading up to 08/31/21; even when removing food and energy, this index rose 4.0% over the same period.  

In addition, upward pressures on inflation may not turn out to be “transitory”, as often described by the Federal Reserve.  There are concerns about possible increased nationalism, protracted supply chain disruptions and continued fiscal policy excesses. If a longer-term upward trend in inflation results, it raises the possibility that forward-looking returns for U.S. Government and Investment Grade bonds may be zero, or even slightly negative.

Despite the aforementioned concerns, there are many reasons to consider including fixed income (i.e. bonds) in a private client portfolio: 

Income generation 

While US Treasury and Investment Grade Corporate yields have reached historically low levels, diversifying into spread products such as asset-backed securities, high yield and emerging market debt can materially improve overall portfolio yields, as well as expected total returns. A diversified, well-constructed fixed income portfolio can provide a stable base of income to a client portfolio’s overall return.

Ballast to counteract stock market volatility

While stock and bonds can occasionally move in the same direction (positive correlation), it tends to hold that economic downturns lead to lower interest rates, bolstering fixed income prices at precisely the time that stock market returns may be turning negative.

Stable withdrawal source for retirees

Retirees are often making regular, monthly withdrawals from their investment accounts to cover living expenses.  Stable, or even slightly appreciated fixed income sources are very appealing for withdrawals when stock market prices are depressed.

Dry Powder

Not all clients look upon their portfolios for regular withdrawals.  During “risk-off” moves, investors often flock to safe-haven assets and central banks initiate monetary policies designed to lower borrowing costs. This combination tends to simultaneously boost the prices for higher quality fixed income assets when equity markets are suffering, creating “dry powder” for reinvesting in out-of-favor assets.

Diversification

By introducing additional asset classes into a stock / bond portfolio, most portfolios enjoy a “smoother ride” (lower return volatility).  For example, many traditional stock / bond portfolios could benefit by including exposure to real estate, which has generated attractive long-term income and appreciation.

Some advisors are recommending that investors “get creative” with their portfolios, adding asset classes such as farmland, hedge funds, private equity and cryptocurrency to diversify and improve income sources.  We recommend that investors approach these more “creative” solutions with caution, since they often contain additional challenges, such as illiquidity.   

Conclusion

While it may no longer make sense to maintain a traditional stock / bond portfolio with US government and/or high-quality corporate debt, fixed income should not be dismissed out of hand.  Investors should work with their advisors to investigate non-traditional bond asset classes and methods to improve portfolio yields and expected overall returns, without substantially increasing risk.