With interest rates at historic lows, inflation fears rising and credit spreads tight, it’s shaping up to be a potentially challenging time for fixed-income investors, leading some to wonder whether it still makes sense to own bonds. Amid such challenges, it’s worth reflecting on the important role bonds play in portfolios.
While not immutable, the correlation between stocks and bonds has been negative for the past two decades. This inverse relationship has helped buffer portfolios during historic equity-market downturns:
- We needn’t look back far to appreciate the importance of diversification. Consider that the S&P 500 fell by about 34% during a one-month period as the global pandemic unfolded last year. As stocks sank, the Bloomberg Barclays U.S. Aggregate Bond Index trended higher, ultimately finishing the year up 7.5%.
- Diversification can not only lower portfolio volatility but allows investors to rebalance at appropriate times in a market cycle. When stocks vastly underperformed bonds last year, investors who rebalanced their portfolios stood to benefit from the rally that began in late March and powered the market to record highs by year’s end.
An allocation to bonds can still provide investors with dependable income, just not at the same levels that previous generations enjoyed. To be sure, this isn’t your father’s bond market:
- In early November, the yield on the 10-year Treasury was nearly 1.5%, about a third of its long-term average.
- In 1990, when the 10-year yielded about 8%, a $1 million investment provided about $80,000 in annual income. That same investment today would provide roughly $15,000 in yearly income.
- With rates so low, investors may be tempted to chase yield by lowering the credit quality or extending the duration of their fixed-income investments. But it’s important to keep in mind that higher-yield bonds (such as corporate or municipal securities) carry a greater risk of default than Treasurys. And if interest rates rise, longer-duration securities (10- and 30-year Treasurys) fall in value.
With inflation worries rising, central banks around the world (from Norway to Brazil) are responding by tightening monetary policy and signaling more tightening to come:
- Last week, the Federal Reserve announced plans to begin scaling back its pandemic-era bond-buying program, noting that “indicators of economic activity and employment have continued to strengthen,” just not enough to warrant higher rates yet. The central bank continued to maintain that elevated inflation reflects factors that are expected to be “transitory.”
- During this recovery, the Fed has been careful to take a sequential approach to tightening (tapering asset purchases before starting to lift rates) so as not to step on two brakes at once. By starting to taper now, the central bank is also putting itself in a position to lift rates if high inflation proves stickier than expected.
- Around the world, short-term bond yields, which tend to rise and fall with expectations for rate increases, have climbed recently. The two-year Treasury yield has more than doubled since early September, climbing to 0.50% last week.
Like the Fed, we continue to believe that inflation will ease as supply-chain disruptions abate. That said, there are certain types of fixed-income instruments designed to protect investors against inflation, and they’re attracting plenty of attention:
- Bond exchange-traded funds (ETFs) took in $17 billion in October, driven by flows into fixed-income asset classes that benefit from higher rates.
- Record-setting flows (more than $6 billion) went into Treasury Inflation-Protected Securities (TIPs) ETFs, reports State Street Global Advisors.
- Bank loan funds had their eighth-highest flows ever (some $860 million).
Given the headwinds facing the fixed-income market, buying bonds can feel akin to receiving a pair of socks as a holiday gift. Yet, just like socks help keep you warm and dry during frosty weather, bonds can help smooth out the highs and lows of a portfolio, along with adding to returns over time and offering some income.
The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Advisor Services Holdings C, Inc., d/b/a Kestra Holdings, and its subsidiaries, including, but not limited to, Kestra Advisory Services, LLC, Kestra Private Wealth Services, LLC, Kestra Investment Services, LLC, Kestra Investment Management, LLC, Bluespring Wealth Partners, LLC, and Grove Point Financial, LLC. The material is for informational purposes only. It represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. It is not guaranteed by any entity for accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was created to provide accurate and reliable information on the subjects covered but should not be regarded as a complete analysis of these subjects. It is not intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be sought regarding your individual situation. Kestra Advisor Services Holdings C, Inc., d/b/a Kestra Holdings, and its subsidiaries, including, but not limited to, Kestra Advisory Services, LLC, Kestra Private Wealth Services, LLC, Kestra Investment Services, LLC, Kestra Investment Management, LLC, Bluespring Wealth Partners, LLC, and Grove Point Financial, LLC does not offer tax or legal advice.