SHOULD AN INVESTOR OWN BONDS WHEN YIELDS ARE SO LOW?

Does it make sense to own bonds when they are paying historically low interest rates? Short answer, yes. There are four main benefits of owning bonds even in a low interest rate environment.

Benefits of Owning Bonds:

1. Diversification (bonds tend to rise when stocks fall)
2. Rebalancing (from bonds to equities, and vice versa)
3. Reduce Risk & Volatility (bonds are higher on the capital structure & less volatile)
4. Liability Matching (pre-fund future spending)

Diversification Benefit
Bonds are inversely correlated to stocks, meaning, stocks and bonds usually move in opposite directions. You can think of bonds as a counterweight to equities. For example, when stocks fall in price, bonds tend to not only maintain their value, but can even appreciate. This diversification benefit is quite important for long-term investors as it can help stabilize account values during tumultuous selloffs. As you can see in the below chart bonds were up 2% while equities were down 23% during the 2020 COVID-19 March selloff.

Additionally, high credit quality bonds such as U.S. Treasuries, tend to be a safe haven asset class. During market selloffs investors tend to allocate heavily into treasuries, driving up their price.

For example, while yields on long-term treasuries are currently near historic lows (below 2%) the total return (yield + change in price) for long-term treasuries this year is an impressive 21.7% as of September 30th.²  Even with low bond yields, this has been an excellent year to own fixed income. Thus, it is important to remember that there is more to a bond return than just yield, price appreciation plays an important factor, especially during market selloffs. This leads us to our next benefit, rebalancing.

Rebalancing Benefit
Stocks and bonds generally move in opposite directions, during an equity market selloff, stocks can fall below their desired target weighting, which can cause bonds to become overweight. This mismatch allows us to trim appreciated bond holdings and invest in equities at depressed prices. This means bonds allow investors the ability to generate capital in order to “buy the dip” (i.e. buying equities when they are perceived to be below their intrinsic value) without having to invest new capital. Rebalancing is a fundamental component of portfolio management. The most meaningful rebalances occur between asset classes, equities and bonds, in order to maintain an appropriate level of portfolio risk, given an investor’s ability and willingness to take on risk.

Reduce Risk & Volatility
An allocation to bonds reduces the volatility of a portfolio’s performance given that bonds naturally have lower standard deviations (i.e. dispersion of returns) when compared to equities.³  For example, a 60/40 portfolio can have a 10-year standard deviation around 7%, while a 100% equity portfolio’s standard deviation can be much higher at approximately 15%.^2,4  Additionally, when it comes to investing in companies, bonds are higher up on the capital structure, which means if a company were to go under and be liquidated, bond holders would receive payment before equity holders. Given this, there is less downside risk to bonds when compared to equities. Managing investment risk is vital when it comes to financial planning and long-term investing.

Liability Matching
What is Liability Matching? Liability Matching is the process of structuring high quality bonds to mature at the same time your liabilities (spending needs) come due, therefore, the liability is pre-funded and essentially eliminated. This tool can be used for funding college tuition, gifting, or even funding the first few years of retirement. This allows your other investments (equities) to grow unencumbered. Having a liability matching ladder can help investors who are taking distributions come out of a market selloff relatively unscathed, as they are using bond proceeds to fund their living expenses, which allows their equities to recover in value before they need to sell those securities for spending needs. Liability matching is an important tool for financial planning and it is most commonly done with treasury bonds or high quality investment grade municipal bonds.

In conclusion, bonds play an essential role when it comes to having a well diversified investment portfolio. These benefits include: diversification, rebalancing, reducing risk & volatility, and liability matching. While some market pundits believe bonds are a thing of the past, recent empirical data suggest bonds are still a key component to an investment portfolio. We at The Mather Group are here for you during these uncertain times and are always happy to discuss these topics in greater detail. Feel free to reach out to us with any questions or concerns you may have. We hope you and your loved ones have a safe and enjoyable holiday season.