(07/03/15) Face the Facts About Bonds

Financial pundits’ banter about the future direction of interest rates has droned on for years, causing a great deal of angst amongst investors who need reliable sources of investment income, observes Ben Johnson, editor of MorningstarETF Investor.

Meanwhile, many asset managers have mobilized to capitalize on investors’ fears, launching an array of new products designed to juice yields, mitigate the effects of rising rates, or both. It’s a recipe for bad investor behavior.

The facts facing fixed income investors today are harsh. Rather than ignore them or try to defy them by investing in some freshly minted cure-all, investors should stand and face them.

Fact 1: Interest Rates Are Low

We are in the twilight of a decades' old secular bull market in bonds. Interest rates are historically low. This is bad news for savers. Low yields equate to low levels of current income.

I estimate that over the next decade the nominal annualized return of Vanguard Total Bond Market ETF (BND), which I use as a proxy for a core US bond portfolio, will be approximately equal to its current yield to maturity of 2.1%.

Strip out inflation and investors are faced with near zero levels of expected real return. Low yields portend low future returns; manage your expectations accordingly.

Fact 2: Interest Rates Will One Day (Maybe Soon) Head Higher

Based on current 30day federal funds futures prices, market participants are betting that the Federal Reserve will raise the federal funds rate sometime late this year or early 2016.

Of course, this is hardly a done deal. There will be plenty of economic data that will emerge in the coming months that could push the timing of a rate hike back.

Also, if and when the Fed raises rates, there is no telling 1) the magnitude of the hike, 2) the timing and magnitude of subsequent increases, or 3) whether the rate hike could send the economy into a lurch and cause the Fed to subsequently reverse course. We are in uncharted waters.

Fact 3: Rising Rates Drive Bond Prices Lower

Bond prices have a seesaw relationship with interest rates. As rates go up, prices go down, and vice versa. When rates rise, it will place downward pressure on bond prices.

These circumstances have been a difficult pill to swallow for a growing class of investors that needs reliable sources of income now more than ever.

Rather than take their medicine, many investors are attempting to defy the odds, reaching for yield and piling on risk in the process.

The Fed’s policy has pushed many investors into smaller, more volatile areas of the market. We’ve witnessed this in the mushrooming of assets in bank loan-, high yield-, and unconstrainedbond funds.

In all of these cases, investors looking to protect themselves against one type of risk are simply loading up on another one.

In the process, many seem to be forgetting the basic case for owning high-quality bonds in a diversified portfolio.

High quality bonds have a permanent place in an appropriately diversified portfolio, as they serve some of investors’ most crucial needs, specifically, capital preservation, diversification, and income generation.

As discussed earlier, the expected returns of a diversified portfolio of high quality bonds today are, to put it lightly, unappealing. That said, bonds still play the role of ballast in a diversified portfolio.

What’s an investor to do? Don’t offload your ballast. In fact, you should consider topping it up. Just over six years in, the bull market in stocks is growing long in the horns.

Let’s assume you are so prescient as to have bottom ticked the stock market—as represented by Vanguard Total Stock Market ETF (VTI)—and invested in a classic 60/40 portfolio consisting exclusively of VTI and BND on February 28, 2009.

At the end of May 2015, assuming you had not rebalanced your portfolio in the intervening years, your 60/40 stock/bond split would have evolved to an 80/20 split in favor of stocks.

Stocks have run and valuations have expanded to the point where US stocks look fairly valued at best.

It is a good time to check your ballast tanks to see whether you’re adequately prepared to sail through any storm that may emerge on the horizon. Don’t replace your ballast with something that might only add risk to your portfolio.

The chief culprits here are junk bonds, bank loans, and other nontraditional fixed income strategies. These tend to be highly correlated to equities, and, as such, they offer little by way of diversification benefits.

This is not to say that they absolutely cannot play a bit part in a diversified portfolio, but they are not a suitable substitute for a core allocation to quality bonds.

As Mark Twain said, “It’s not return on my money I’m interested in, it’s return of my money.”