As we all know, one of the outcomes of the Great Recession of 2008 was a collapse in interest rates. With short-term rates still hovering just above 0%, and longer-term, 10-year rates holding at just above 2.5%, there can be no argument that rates remain amazingly (and for some, uncomfortably) low.
Given the rock bottom level that we find in the world of interest rates, it is understandable to conclude that it doesn’t seem to make much sense to hold bonds, or bond funds, in your investment portfolio. After all, the current rate of interest paid by such funds will likely be quite miserly. And since everyone knows that the next big move in interest rates would have to be up (bonds normally struggle in a rising rate environment), an obvious question is – why own any bonds at all?
Not so fast. As with so many things in the world of investing, what would seem to be obvious is not always correct. So it may be with bonds today.
First, a bit of history. One of the most significant periods of a rising interest rate environment that ever took place was from the mid-1960’s through the early 1980’s. During that period, the yield on 5-year treasuries tripled. Yet, according to Ibbotson Associates, the total return for intermediate term bond funds from 1966 through 1981 was a gain of 5.8% annualized.
Wait a minute. A 5.8% annualized gain? That’s pretty good! How could that be? With interest rates rising, surely those bond funds suffered, right?
No. It turns out that as bonds within the fund’s portfolio matured, the proceeds were reinvested into new bonds – at the prevailing higher interest rates. And that’s the key. Those higher reinvestment rates more than made up for any price losses incurred by the bonds themselves within the portfolio. That’s exactly how the total return from 1966 to 1981 was an annualized gain of 5.8% for intermediate bonds, even in the midst of a very hostile interest rate environment.
So, here’s a general rule of thumb: The greater yield earned by reinvesting when rates are rising generally offsets any adverse price decline of the bonds, so long as you hold the bonds or bond fund for a period of time commensurate with the average maturity period of the bonds in the portfolio.
Now there is a second and very important reason why bonds have a place – and for many a prominent place – in your investment portfolio. They have historically been a really good shock absorber during adverse times for stocks. Look at the record –
Since 1928, stocks have suffered 24 negative years – roughly 30% of the time. As it turns out, during those 24 negative stock years, bonds gained in value in all but five of those difficult years. And as you can see, during those five years where bonds didn’t rise, the declines were quite small.
The data speaks for itself. While your major returns will generally come from stocks, having an allocation to the risk-mitigating characteristics of bonds can be quite useful. Indeed at times it is almost required so as to give your psyche the ability to stay the course when the markets turn hostile – as they tend to do, from time to time. The performance table above beautifully illustrates the benefits of holding a non-correlated (that is, not moving together in-tandem) asset class (bonds) to compliment your exposure to stocks. Holding an exposure to bonds within your portfolio really is a case where the whole is much more effective than the sum of the parts.
So, keep this information handy the next time you hear about or question the wisdom of holding bonds in today’s interest rate environment. If you match the average maturity of your bonds, or bond fund with your investment time horizon, you can then use your bonds as an effective shock absorber for your entire portfolio. Do that and it is highly likely that at some point you will come to appreciate the value of effective portfolio diversification, up close and personal.
Finally, remember this. When it comes to investing, if something seems obvious – it may well be obviously wrong.