The Henderson Group | With Yields Poised to Rise, Why Own Bonds?
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With Yields Poised to Rise, Why Own Bonds?

With Yields Poised to Rise, Why Own Bonds?

Key Points

  • With the potential for bond yields to move higher rather than lower, investors may be concerned about the risk of lower prices.
  • Bonds can help diversify an overall portfolio, and the predictable coupon payments and maturity date can help with financial planning.
  • Historically, bad years in bonds haven’t been as bad as bad years in stocks, and bonds can still earn a positive total return if yields increase.

Even after a steep increase last year, bond yields are still low by historical standards. Depending on the pace of economic growth, we think there’s a greater chance for yields to move higher than lower in 2014. With that expectation, some investors may question why it makes sense to hold bonds at all. While it’s true that bond prices and yields move in opposite directions—meaning higher yields lead to lower prices—we don’t think investors should avoid bonds altogether. Bonds still offer many benefits, and we think they should remain an important part of most investors’ portfolios.

Coupon payments can help offset price declines. That’s the beauty of bonds—they offer coupon payments for investors looking for a consistent stream of income. While it’s true that a higher yield will lead to a lower bond price, that’s only half of the equation when it comes to performance. For most traditional bonds, total return is composed of price return and income return. Take, for example, a five-year bond with a 3% coupon, priced at par to yield 3% annually. If interest rates rise by 100 basis points (1%), the price of the bond will drop by approximately 4.6%, all else being equal.1 However, you’ll still earn your 3% coupon, resulting in a one-year total return of about −1.6%. That return, however, would only be realized if an investor sold the bond. While the price return can fluctuate, the income return is always additive for bonds that have a coupon payment and this can help to act as a buffer to falling prices.

Not all bonds are alike. It’s easy to focus on the ups and downs of the yield on the benchmark 10-year Treasury bond, but there’s a large, varied universe of fixed income investments out there. If long-term interest rates rise as we expect this year, some bonds are likely to perform better than others. Focusing on the maturity and credit profile of the bonds can help investors mitigate some of the impact of rising rates on their fixed income investments

A bad year for bonds has historically been very different from a bad year for stocks. Since its inception in 1976, there have only been three years in which the Barclays U.S. Aggregate Bond Index has generated a negative total return. The S&P 500 Index, on the other hand, has generated negative total returns in seven years over the same time period. And the magnitude of the decline in bonds was significantly lower than that of stocks, as seen in the chart below. The worst total return of the Barclays U.S. Aggregate Bond Index was −2.92% in 1994. This compares to −37.00% total return for the S&P 500 Index in 2008, the worst total return of our study. We think it’s important to highlight the 2013 performance of the Barclays U.S. Aggregate Bond Index. For the year, 10-year Treasury yields increased by 128 basis points—from 1.75% to 3.03%—but the total return of the aggregate bond index was only −2.02%.

While no one wants a negative total return from their bond holdings, we think that the total return was better than many would have imagined considering the dramatic rise in Treasury yields.

Since 1976, the worst-performing years for stocks were much more negative than the worst years in bonds

Source: Schwab Center for Financial Research with data provided by Morningstar, Inc. The chart shows the three lowest total annual returns from 1976 through 2013. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results.

Bonds mature. Any change in market yields on the price of a bond may not matter much if you buy bonds for the known maturity and cash flow. Many investors purchase bonds for the relative safety compared to stocks and the predictability of income they provide. The most important factors are that they make coupon payments, and then repay principal on the maturity date. And bonds can play a large role in financial planning. Since bonds mature on a specified date, barring default, investors know how much money they’ll have available in the future. This can help with specific fixed expenses down the road, such as education expenses or income needed for retirement. These characteristics are specific for individual bonds, not bond funds. While many investors may be concerned that the price of a bond fund will likely drop when rates rise, an investor holding individual bonds to maturity doesn’t necessarily need to worry about that.

Bonds help diversify an overall portfolio. Different investments serve different purposes in a portfolio. Eliminating one could result in a more volatile portfolio. A properly diversified portfolio should have various asset classes that don’t all perform the same under different market conditions. If one asset class is going down, you don’t want all of your other investments going down as well, although this can happen. To look at the diversification benefits of various asset classes, we look at their historical correlations with each other. Correlation is a statistical measure of how investments move in relation to each other. Over the past 20 years, the Barclays U.S. Aggregate Bond Index and the S&P 500 Index have had a correlation of 0.04—almost no correlation at all. This can help reduce the overall volatility of an investor’s portfolio.

What to do now. While the prospect of rising Treasury yields will likely lead to lower bond prices, that doesn’t mean investors should avoid bonds altogether. Moreover, bonds can generate a positive total return, even in a bond bear market. We think it’s important to remember the income and diversification benefits bonds provide in an overall portfolio. Selecting the right type and maturity of bonds in a well-balanced portfolio can be key to managing the interest rate environment.

By: Collin Martin

CFA, Senior Research Analyst, Fixed Income, Schwab Center for Financial Research

1. The duration of a five-year bond with a 3% coupon priced at par is approximately 4.6. All else being equal, an increase in yield of 100 basis points (1%) results in a fall in price equal to the duration. In this example, the fall in price would be 4.6%.

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