Yield surge: Remember the real role of bonds
April 17, 2017
Bond rates continue to make headlines as the U.S. economy picks up steam and the Fed raises interest rates again.
If you're feeling unsettled by the upward trend in yields, it might be helpful to remember why you invest in bonds: They can provide stability for your portfolio when stock market volatility increases.
It's also helpful to keep in mind that higher interest rates tend to be good for long-term bond fund investors. Here's additional perspective on recent interest rate increases and what they could mean for you.
Perspective on rising rates (in general)
- Changing expectations move rates and bond values. Higher rates (with a modest increase in inflation) mean a healthy economy and higher-income opportunities, both of which are good for long-term investors. This is a goal the Federal Reserve and policymakers have been working toward for some time.
- Because you're investing at higher rates, you'll typically be better off in the long term with a rise in rates today—if your time horizon is longer than the duration of your bond holdings.
- There's no guarantee rates will continue to rise in the short term. Unexpected fiscal or monetary policy events could result in downward pressure on rates. Remember, rates don't have to rise just because they're low. And they don't have to keep rising just because they have recently.
- Shorter maturities may help protect principal in the short run but could lower income over the long run.
What's driven rates up?
- Some market participants are projecting that U.S. economic growth could see a short-term boost under President Trump's agenda. That said, many factors beyond policy proposals affect the prospects for growth, such as labor market and productivity trends.
- Other strong contributors to U.S. economic growth, like a more robust job market, are pushing yields up.
- Markets are also responding to increasing expectations that the Fed will raise rates two more times in 2017. The Fed is still saying that future increases will be gradual, which is likely to translate into lower bond market volatility and a more benign environment—not one in which rates rise sharply.
Role of bonds in your portfolio
- Successful portfolio construction isn't just about returns. Bonds help provide diversification and downside protection (offsetting potential equity losses). Conversely, when bonds decline, the equity portion of a balanced portfolio can often offset the loss.
- While Treasuries have seen the biggest price declines in the recent surge, these high-quality bonds have been great diversifiers against equity losses. We've seen this counterbalancing relationship in the past—most recently in August 2015, January 2016, and June 2016.
- Diversifying bond exposure globally (and hedging the currency risk) can mitigate the short-term risks of a rise in domestic interest rates without altering your asset allocation.
Risk: Bonds versus stocks
- On average, we've seen negative returns in bonds once every six years. We've seen negative returns in stocks once every four years.
- The magnitude of historic losses in stocks versus bonds is very different. The stock market's worst 12-month return was a decline of 67.6% (S&P 90 Index, ended June 30, 1932). The bond market's worst 12-month return was a decline of 13.9% (Lehman Brothers U.S. Long Credit AA Index, ended September 30, 1974).
- All investing is subject to risk, including the possible loss of the money you invest.
- Past performance is no guarantee of future returns.
- Diversification does not ensure a profit or protect against a loss.
- Bond funds are subject to the risk that an issuer will fail to make payments on time and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.