Bonds have a long history of being vital sources of capital preservation and income in investment portfolios, particularly for retirees. But that reputation is fading.
Yields on high-quality corporate bonds and risk-free U.S. Treasuries have been marching lower for the better part of 40 years, to the point where they no longer provide the level of income that most retirees need from an investment portfolio:
U.S. Treasury and Corporate Bond Yields Have Been Falling Since the Early 1980s
Source: Federal Reserve Bank of St. Louis1
The risk-free rate (U.S. Treasury yield) now hovers around 1%, which means that bond investors today are likely to lose purchasing power over time given the effects of inflation. The outlook also remains fairly bleak: interest rates are actively being pushed lower by the Federal Reserve and central banks across the world, with bond buying and stimulus programs running at near full steam. The end result is that interest rates are not likely to move substantially higher for several years, in my view.
This environment may have many investors wondering whether it’s worth owning bonds anymore. I think the answer first depends on your tolerance for volatility, your income needs, and your long-term goals. I personally would argue that a majority of investors do not need significant fixed income in an investment portfolio with a long-term time horizon. But that does not mean bonds are dead, or that they can no longer play a vital role for some investment strategies.
For one, bonds can still be used to diversify a portfolio and reduce risk. Looking at the S&P 500 Index and the Bloomberg Barclays Aggregate U.S. Bond Index over the last ten years, there is basically zero correlation between the two.2 When bonds zig, stocks zag, and vice versa. For investors, that means when stocks in a portfolio experience price declines, bonds usually see price increases. The end result is less portfolio volatility – an outcome that’s important for many investors, even if it means slightly lower total returns over time. Second, even though most high-quality bonds are paying very little interest at the moment, they still offer very high probability of principal protection – which, again, is important to some investors. The so-called ‘sleep at night’ factor.
At the end of the day, the issue I see in the bond markets today is less about low interest rates and more about investors “reaching for yield.” There is a trend among retail investors of moving further out on the bond risk curve in order to obtain income, in many cases buying lower quality high-yield bonds and even emerging market debt (where yields are much higher). If that sounds like you, then maybe it is time to sanity check the role of bonds in your portfolio, and decide whether they’re worth owning at all. Chances are, you can produce similar levels of income with better risk profiles elsewhere, for example in dividend-paying value stocks.
Bottom Line for Investors
Bonds continue to serve many key functions in portfolio management. And for many older investors, bonds are – and will remain – a bedrock for your investment strategy.
But in the current market environment, no single bond investment is capable of producing the income and principal protection that many investors seek. Investors need to get creative, and I think one smart option is to build a customized portfolio of high-quality corporate bonds coupled with dividend-paying value stocks, to strike a balance between income, stability, and long-term growth.