Market Analysis

How to Think About Bonds Now

Some simple portfolio adjustments can help bondholders prepare for potentially higher yields.

With long-term sovereign bond yields sitting near rock-bottom lows after a sharp year-to-date decline, many wonder what lies ahead. Some speculate rates have even further to fall—hence, the steady demand for super-low and even negative-yielding bonds. Others, however, expect a reversal—with rates rebounding some as recession fears abate. The US yield curve’s return to a positive slope on Friday morning might spur that sentiment even more, which may raise the question of how to position today. With rising yields come falling bond prices, potentially making bonds appear unattractive: If bonds’ purpose in a portfolio incorporating a mix of bonds and stocks is to reduce expected short-term volatility, the prospect of declining prices may seem counterproductive. But we don’t think it should. Potentially rising long-term interest rates might be reason for bondholders to tweak the mix of bonds they own, but we don’t think it is reason to ditch them outright.

First, rising yields don’t necessarily mean sinking bond returns. The reason: Price movement is only part of a bond’s total return. The other is its yield. Since the two move in opposite directions, rising yields can help offset price declines. Consider a bond yielding 1%. If yields on equivalent bonds rise to 2%, its price would fall. But the interest payments may keep its total return from deteriorating much. Small increases in 10-year US Treasury yields in 2015 and 2016 didn’t bring negative bond total returns.[i] Neither did 2009’s 1.78 percentage point climb in Treasury yields.[ii] In a diversified bond portfolio in which maturing bonds are reinvested at the new higher rates, price declines’ effects can be even more muted.

Bonds can also still do their primary job—dampening portfolio volatility—even if total returns are muted or negative. Last year is a good example, as the S&P 500 fell -4.4% while bonds ticked down -0.8%.[iii] Importantly, volatility is about moves’ magnitude, not their direction. This means an investment whose value fluctuates 5% annually on average is more volatile than an investment that fluctuates 3% annually on average, even if the former’s returns are positive and the latter’s are negative. Hence, declining bond values in a blended portfolio doesn’t mean it is more volatile than an all-equity portfolio. In all likelihood, it will be less, since bond returns tend to be less bouncy over shorter time periods. For example, during the two sustained stretches of rising bond yields (and falling prices) during this expansion—August 2012 – August 2013 and July 2016 – October 2018—US stocks’ average monthly volatility was more than twice that of long-term bonds’.[iv] Those holding bonds to reduce short-term portfolio volatility were likely rewarded.

There are also ways to position the bond portion of your portfolio to reduce its vulnerability to rising rates. The first is by adjusting your bonds’ duration. Duration measures bond prices’ sensitivity to changes in prevailing interest rates. It varies primarily based on a bond’s maturity and stated interest rate. Higher duration means more interest rate sensitivity—rising or falling interest rates on similar bonds have a greater impact on bond prices. Conversely, prices of low duration bonds don’t respond as much to interest rate fluctuations. So if you think rising yields are increasingly likely, reducing the duration of your bond holdings may make sense. One common way to do so is by increasing exposure to shorter-term bonds. Because they mature earlier, their prices aren’t as sensitive to interest rate fluctuations.

The second way to adjust your bond holdings to prepare for rising yields is by emphasizing higher-yielding bonds. Their higher interest rates should lift your holdings’ total return, helping offset declining bond prices. In our view, this means favoring quality corporate bonds over low-yielding US Treasurys. In particular, we think corporate bonds with shorter maturities can reduce duration while preserving somewhat higher yields than comparable maturity Treasurys.

Moreover, while corporate bond prices could dip in rising yield environment, we think corporates can still outperform other bond options, such as Treasurys. Corporate bond prices do not move exclusively with inflation or interest-rate changes. The issuing firm’s financial health matters, too. Later in expansions, rising revenues tied to economic growth bolster firms’ balance sheets, rendering debt servicing easier. This gives investors more confidence in their health, encouraging them to bid bond prices up. For this reason, corporates tend to be less interest-rate sensitive than Treasurys. Hence, credit spreads—the difference in yield between two bonds types with similar maturities—often narrow late in expansions. This, plus corporate bonds’ higher yields, suggest to us corporate bonds are more attractive than Treasurys presently.

[i] Source: FactSet, as of 10/11/2019. 10-year US Treasury yield annual movement and ICE BofA Merrill Lynch US Corporate-Government 7-10 Year Index total return.

[ii] Ibid.

[iii] Source: FactSet, as of 10/11/2019. S&P 500 and ICE BofA Merrill Lynch US Corporate-Government 7-10 Year Index total return, 12/31/2017 – 12/31/2018.

[iv] Source: FactSet, as of 10/10/2019. 20-trading rolling average volatility of the S&P 500 Total Return Index and the ICE BofA Merrill Lynch US Corporate-Government 7-10 Year Index, 7/25/2012 – 9/5/2013 and 7/5/2016 – 11/08/2018.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.