Often, when discussing portfolio allocations with clients, I will get asked a question or two that goes something like this, “The Federal Reserve is raising interest rates. Why would I want to own bonds?” or “Yields on bonds are pretty low, shouldn’t I just own dividend-paying stocks instead?” or “Bonds aren’t making any money, look how much they lagged behind stocks. Tell me again; why do I want to own those?”
All of these are valid points. Post-2008 (Great Recession), we haven’t seen 4% rates on 10-year treasury bonds. From the early 1960s through the early 2000s, we didn’t see rates on 10-year treasuries ever fall below 4%, so the argument about rates on bonds being (relatively) low for the last decade plus is sound.
The Federal Reserve
If you weren’t familiar with the relationship between rising interest rates (a task which the Federal Reserve has been undergoing for the last three years) and bond prices, it can be summarized like this: when interest rates go up, bond prices go down. Let’s say Company ABC issued a bond last year and is paying investors 3% per year. Fast forward to today. Interest rates have risen, and now Company ABC needs to pay investors 5% per year on their newly issued bonds.
You were an investor in the original 3% bonds, and you’d like to sell those to get in on the higher yielding bonds. In order for me to buy your old, lower rate bonds, you’re going to have to sell them to me at a discounted (lower) price. The argument against bonds right now being, if rates continue to rise, shouldn’t we see a drop in the price of bonds? Why would we want to own something that we think will lose value?
For years, we’ve heard about how the Federal Reserve would raise rates, and there would be some sort of crash in the prices of existing bonds. Three years into the rising rate environment which began in the 4th quarter of 2016, and we’ve seen the Fed Funds rate rise by more than 2%. However, we haven’t seen a crash in bond prices.
The Argument for Owning Bonds
Allow me to present an argument for owning bonds even though we find ourselves in a rising rate environment. In addition to decade-low yields on bonds today.
- Bonds of higher quality (US government or highly rated corporations) provide diversification and low correlation to US stocks. You don’t want everything in your portfolio performing the same at all times. This becomes important when multiple asset classes become highly correlated (see 2008).
- Bonds provide a hedge against a stock market decline. You don’t have to look far back to see how well bonds hold up during bear markets. Over the last 20 years, we’ve seen a 40% and 50% decline in US stock prices at two separate points. Over that period, the most significant drawdown in a 100% US Total Bond fund, such as the Vanguard Total Bond Market Index Fund (VBMFX) was about 4%. The downside drawdowns don’t compare. Unless you have the intestinal fortitude to ride out a considerable drawdown in your portfolio’s value, bonds can help reduce your drawdowns. Making it easier to stick with your investment plan.
- Thinking about replacing your low-rate bonds with higher rate dividend-paying stocks? Know you’re comparing apples with oranges. The dividend rate on the Vanguard REIT ETF (VNQ) is about 4% today. The yield on a short-term Treasury ETF, such as the iShares Short Treasury Bond ETF, sits around 2.3%. Many investors, searching yield over the past decade, have abandoned bonds. As a result, flocking to value stocks, REITs, or other high-yielding equities. This is a “it works until it doesn’t work anymore” types of plans. During the financial crisis, the US treasury continued to make semi-annual interest payments. During that period, S&P 500 companies would cut dividends by nearly 23%, while share prices of the companies were also slashed (double whammy).
To Wrap Things Up
Bonds may be able to provide a more steady, predictable income stream during a bear market than dividend-paying stocks (depending on the type in question).
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Investment advisory services offered through Barber Financial Group, Inc., an SEC Registered Investment Adviser.
The views expressed represent the opinion of Barber Financial Group an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Barber Financial Group does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.