Much Ado About Bonds

Miss Prosperity 1933, wearing a huge dress made of bonds. Photo by Henry Guttmann/Getty Images.

If you believe the headlines, bonds are on the brink of a big bear market—mostly because they’ve spent ages in a big bull and interest rates can’t get much lower. Many investors see this as reason to flee—a perilous path, in our view. For one, just because bonds have experienced a multi-decade bull market doesn’t mean a bear must follow. Plus, investors should consider bonds’ larger purpose in a diversified portfolio. Even though interest rates might rise some over the period ahead, bonds can still play an important role for investors (depending on their long-term goals, time horizons and other personal factors).

Bonds, like stocks, move on fundamentals—not gravity, mean reversion or any other force folks erroneously try to ascribe to capital markets. Nor do bonds automatically move in generational cycles—that they seemingly have lately is incidental. Like stocks, they move on fundamentals over the next 12-18 months. Expectations for inflation, economic growth, Fed policy changes and the like will all drive interest rates (and bond prices) looking forward, and there doesn’t appear to be a catalyst for rates to shoot sky-high and stay there. Granted, with interest rates still hovering around generational lows, they likely will rise at some point. But maybe they rise and fall, go sideways or bounce around a bit. Any number of variables can impact bonds, and the further out you look, the more unknown those variables become. Anyone forecasting what bonds will do over the next 3, 5, 10 or 40 years has no rational basis for their prediction.

Then again, perhaps a bigger problem with the heightened focus on bonds’ long term return potential is the basic assumption investors use bonds to generate return. Maybe some do, but in our view, this is a very flawed approach. Investors with lengthy time horizons seeking long-term growth typically fare best in categories with higher expected return characteristics, like stocks. Bonds serve a different purpose: helping reduce expected short-term volatility, either to help support ongoing cash flow needs or simply help some folks feel more comfortable. For these investors, a fixed income allocation is an important piece of their long-term strategy—and strategy should depend on long-term goals, time horizon, cash flow needs and other personal factors, not the short-term performance outlook. If investors need bonds in order to reach their goals over time, dumping them at this juncture would be short sighted—it could throw the portfolio’s expected risk and return out of whack. For example, if they rushed headlong into stocks based on their higher return potential, they could increase portfolio volatility—counter to their aims. Or, someone looking for a “safe” bond alternative (which doesn’t exist—no asset is inherently safe) could end up in costly, illiquid products.

Investors can change their tactical approach as the market outlook changes. Yet making a permanent strategy change based on market outlook, particularly a long-range forecast, is likely folly. Besides, investors can use a few different tactics to navigate potential rising rates. For example, they could shorten the bond portfolio’s duration (i.e., increasing the allocation to shorter maturity debt securities). This typically makes the portfolio less sensitive to interest rates (though this also generally comes at the expense of a lower yield). Or, folks can concentrate in corporate bonds, which tend to hold up better than Treasury bonds as interest rates rise and credit spreads narrow.

In short, while bonds aren’t without risk, their current risks appear overstated today. So, as ever, investors should stay disciplined, keep an eye on fundamentals, and keep their long-term goals, time horizon, cash flow needs and overall financial situation top of mind.