The Role of Bonds in Client Portfolios

The Role of Bonds in Client Portfolios

Given the recent volatility in the bond markets, we thought it would be an appropriate time to send out a message on what role bonds play in your portfolio. We welcome your feedback and hope that you have been enjoying your summer so far, in spite of the recent market volatility.

Bond prices go up when interest rates go down, and rates have been doing just that since the Reagan Administration. Back in 1982, 10-year Treasuries were paying 15%, and after 30 years of steady decline, they dropped below 2% last year and trended down slightly for the first part of 2013. This remarkable three-decade drop in interest rates has been described as the ultimate bull market in bonds, perhaps the most rewarding period for bond investors in all of investment history.

However, it's hard to see how bonds can continue much further on the same trajectory, unless you're predicting that people are going to be willing to pay for the privilege of owning Treasuries. Market prognosticators--whose profession is less than reputable--have been predicting for years that rates will go back up, perhaps dramatically, creating losses in the fixed-income part of your portfolio. So the obvious question is: why should we have a portion of each investment portfolio in bonds?

The purpose of bonds in an investment portfolio is not to generate high returns--the past golden period notwithstanding – but to reduce overall volatility in your long-term portfolio. Bonds protect against the worst kind of market risk--the times when stocks suddenly, unexpectedly plunge. The last time stocks took a nosedive, in 2008, U.S. equity markets seemed to be sailing toward another year of gains and bond prices were experiencing 30 year lows.

Why own bonds in an environment like that? Yet by the end of the year, a mixed portfolio of bonds had achieved a 5.24% positive return, while stocks were losing 37%--meaning bonds outperformed stocks by more than 42 percentage points. In 2000, 2001 and 2002 when stocks dropped 9.11%, 11.89% and 22.10% respectively, bonds rallied to give investors returns of 11.63%, 8.43% and 10.26%. Over time, investors holding bonds enjoy a smoother market ride, and experience fewer losses during market downturns.

More importantly, having bonds in your investment portfolio gives you options if and when stocks fall. If you need income, you can liquidate the bonds, rather than having to sell stocks at a loss. If the prices of stocks drop to the point where stocks become a screaming buy, you have some money set aside to buy at bargain prices and make up some of the losses.

If and when interest rates reverse themselves, and yields move up, you will observe decreased values in the bond portion of your portfolio. We help manage this risk by reducing the maturity or duration of the bonds from 10 years to 5 years or less and using inflation-protected securities. We have been doing this for our clients at Pauley Financial, in anticipation of an inevitable move up in interest rates. We believe that bonds still play an important role in your portfolio, as do multiple other asset classes that we use in portfolio construction. During the course of an economic cycle (3 to 7 years), each asset class ‘has its day’ and helps provide overall growth in your portfolio.