Let’s talk about bonds. We don’t talk about bonds very often. Bonds are boring.
What purpose do bonds serve in your portfolio? Most people would answer to provide income since bond interest rates are usually higher than stock dividend yields.
We would propose a different answer. The purpose of bonds in your portfolio is to cushion the volatility of stocks. Bonds are your anchor in a storm.
Bonds are not necessarily a good source of income since stock dividend yields are about equal to bond interest rates, and stock dividend income generally grows over time as companies increase profits and dividends. Bond income fluctuates with interest rates.
Bond prices move in the opposite direction of interest rates. This is because if interest rates go up, no one wants to buy an old bond when they can buy a new bond for a higher interest rate. So the price of older bonds goes down. For over 35 years, bond prices increased as interest rates went down from their peak rates in the high teens in the late 1970s and early 1980s to almost 0% after the 2008 global financial crises.
Now, nearly 10 years after the 2008 financial crises, we are entering a rising interest rate market. Fears of inflation caused by an increase in wage growth in February sparked an increase in interest rates. The Federal Reserve policymakers also raised short-term interest rates to slow economic growth and reduce the risk of inflation.
So bonds have had modest losses in 2018. The Bloomberg Barclays U.S. Aggregate Bond Index (the foremost U.S. bond market index) has declined 2.19% in 2018. The comparable tax-free bond index was down 1.46%, and the inflation-adjusted bond index was down 0.85%.
These losses aren’t painful, but they hurt given relatively slight losses in stocks this year. Bonds haven’t cushioned a stock portfolio in 2018, but bonds act as better anchors in a major stock market downturn. Remember, we haven’t had one of those in a long time.
Our strategy includes using short-term bond funds due to the fact that they decline less in a rising interest rate market and they start earning a higher interest rate faster. Our strategy also includes using inflation-protected or real return bond funds, which protect against inflation. Inflation has been low but has been slowly increasing.
Overall, your bond portfolio is well positioned to perform better in both a rising interest rate and rising inflation rate economy than a traditional bond fund. Your bond portfolio continues to serve as an anchor against any stock market storm that whips up without notice.
As always, please contact us with any questions, news, or comments.