Bonds are off to their worst start to the year ever. You may be wondering, what do I own these bonds for anyways? Here are some things to think about when considering the role of fixed income in your portfolio.
1) Volatility Dampening
High-quality, short-duration fixed income is added to a portfolio primarily to lower its overall volatility.
Let's use Spring of 2020 as an example. At the onset of Covid 19, US Stocks as a group fell about 21% from their highs in February and March of 2020. A portfolio of all Intermediate-Term US Treasuries actually increased in value as part of investors overall flight to safety. A portfolio consisting of half US stocks and half US treasuries went down about 8%.
In this case, the investor who spread their investments across stocks and bonds experienced a lower drawdown. In this case, the portfolio components did the job that they were set out for. In my opinion, the volatility dampening aspect of high quality fixed income is still its main benefit. For financial and for behavioural reasons.
While individual bonds do not offer daily liquidity to investors, open ended bond mutual funds and ETF's do offer liquidity. Liquidity simply means a way to trade your investment for cash in the short term. Cash proceeds from short-term fixed income can be used to pay your bills and to rebalance your bond fund into other areas of the portfolio when they temporarily go down in price. Investors cannot get this benefit from GIC's or individual bonds. In my opinion, fixed income still plays this important role in portfolios.
3) But bonds aren't supposed to go down in value are they?
We have been very spoiled by high positive returns for fixed income over the past several decades. Now that they have realized some negative returns, it may cause you to wonder whether we should be looking at an alternative to bonds? First, let's dispense with the idea that bonds are always going up. See below a chart from Portfolio Visuzlizer - Intermediate US treasuries have seen drawdowns equal to or worse than what we are experiencing today:
Yes, this chart looks not-great. But when you compare drawdowns of -8%-10% in bonds against the bone-crushing drawdowns of between 30% and 50% for stocks, it helps maintain your perspective.
4) Bonds' Expected Future Returns is Rising (Now)
If there is a silver lining to the rough ride that bonds are going through right now, it's that future bond returns are now higher going forward? The largest determinant of future bond returns is the starting yield. As yields rise, bonds maturing in bond fund will be able to be re-invested at now-higher current interest rates. This will produce higher expected future returns for bonds.
One of the things about following financial news on the internet is that you get to see some pretty awful opinions. Some of the worst things that I have seen over the past few months have been from commentators saying you should swap out your fixed income for dividend-paying stocks or tech stocks, or alternatives like commodities and private credit. To me, these are all shades of the same flawed argument - the answer to low bond returns is to simply swap it out for a completely different asset with a completely different risk/return profile.
I think this is mistake.
If you have built your portfolio, allocated it properly to asset classes (stocks and bonds, value, small cap, profitable stocks, international stocks, etc.), the answer to the current bond environment is to simply stay the course and tune out the noise.