Surprise! Interest rates are falling. The 10-Year Treasury rate has fallen from 2.6% at the beginning of the year to a 2.18% as of the end of May, a level not seen since 2017. This decline counters the conventional wisdom, and many economists who had generally predicted gradually rising interest rates. Rather than facing the headwinds of rising rates, bonds have experienced a tailwind of falling rates and have had a very good year so far. The Bond Aggregate Index returned more than 4% through the end of May. The results remind us of the important role that bonds play in a diversified portfolio. Bonds provide capital preservation, income and diversification.
Unlike equities, bonds are a promise to pay at a specific date in the future, and are backed by the company that issues the bond. You can think of a bondholder as giving a loan to the issuing company. This makes bonds appealing to investors who don’t want to risk their money in the stock market, want predictable income, or who may need the money back at a specific point in the future. (Think pension plans, insurance companies, and retirees). Importantly, since the cash flows from bonds are predictable, they are also generally easy to value, and absent a significant decline in the creditworthiness of the issuer, are much more stable than stocks. Therefore, bonds provide the important role of capital preservation in a diversified portfolio.
Income and Appreciation
Bonds provide income in the form of interest and capital appreciation from changes in the price of the bond. Bond prices can rise and fall for several reasons. For example, if interest rates fall bond prices will generally rise, providing a tailwind for returns like we have had in the first part of 2019. A second example is when the creditworthiness of the issuing company improves, which generally makes the bond more valuable and increases the price. If a bond is held until maturity any price gains (or losses) over the life of the bond are not realized since bonds will typically mature at 100 (100 cents on the dollar), erasing any price changes during the life of the bond. However, a good manager can sell appreciated bonds and realize this capital appreciation, providing return above the interest on the bond. A bond’s total return will be a combination of the interest on the bond and any capital appreciation realized on the bond.
The most important role that bonds play in a portfolio is diversification. Bonds help protect investors from economic slowdown or recession. In fact, when the economy is slowing and stocks fall, bonds will often increase in price. The reason is simple. Bonds provide a fixed income that doesn’t change. During a period of economic slowing, the value of a predictable income stream becomes more valuable. It is this countercyclical nature that provides the most diversification benefit to bonds. When stocks perform well, bonds will often lag (but are usually still a positive contributor). Conversely, stocks do poorly, bonds will often perform well, providing a well. Pairing both stocks and bonds in a portfolio provides an investor with a more predictable return.
In summary, the well diversified portfolio should have an allocation to bonds, which provides capital preservation, income, and diversification. They are particularly valuable during downturns, or periods of economic stress where they provide an important offset to the behavior of stocks.