Investors need to balance the expected fall of bond prices (portfolio ladder, tactical managers) with the benefits (equity hedge, price stability) that fixed income brings.
The 10-Year hit 3% at the end of 2013 while the Aggregate
Bond ETF fell just under 2%:
Not to beat the thesis to death (see the bold paragraph here),
but moving forward rates are expected to rise.
If we assume this to be the base case and bond prices fall, a logical
question is why hold bonds at all?
To answer that, let’s first examine the roll of a fixed
income portfolio:
- Despite being correlated over longer time periods, bonds can provide stability in the event equities fall. From August 2007 to March 2009, using monthly closes, US stocks had an annualized return of -30% while US bonds had an annualized return of 6%. Diversification away from equities with bonds minimized portfolio volatility.
- Utilizing the same data going back to 1970, we see the max drawdown on US stocks was 51% while for bonds in was 13%. Thus, historical returns indicate the largest amount of risk in a portfolio is from stocks.
- See the above, that even with a 70% plus climb on the 10 year interest rate, AGG was only down 2%. For returns of other Fixed Income ETFs, see here.
- A caveat to the previous bullet is making sure the portfolio’s duration risk (the sensitivity to interest rate changes, the higher the duration the greater susceptibility to rising interest rates) is managed. If we look at TLT (iShares 20+ Year Treasury Bond) the duration is over 16 years and the ETF was down roughly 17% in 2013.
To summarize, a fixed income portfolio with managed duration
risk can provide a hedge against a falling equity market and is not at a high
risk for large principal loss. Still, we
are left balancing the prospect of rising interest rates with the
diversification benefits that fixed income bring:
- Laddering individual bonds or ETFs with a set maturity assures that an investor face value of the bond back (assuming no default) and can lessen the sensitivity to interest rate changes as bonds that come due will be re-invested at higher rates.
- Utilizing tactical managers who can enhance returns even if interest rates are rising.
- Find attractive relatively attractive yields in fixed income (e.g. municipal bonds).
While these ideas attempt to weigh rising rates with
diversification, ultimately there is no free lunch – any move to hedge
against rising rates probably reduces one’s ability hedge against a falling
equity market. It’s imperative each
investor recognizes this and then decides on his or her own course of action.
The views and opinions expressed herein are those of the
author(s) noted and may or may not represent the views of Capital Analysts,
Inc. or Lincoln Investment. The
material presented is provided for informational purposes only. Nothing
contained herein should be construed as a recommendation to buy or sell any
securities. As with all investments, past performance is no guarantee of future
results. No person or system can predict the market. All investments are
subject to risk, including the risk of principal loss.
