What Role Do Bonds Play in Your Portfolio?

Financial professionals typically add bonds to portfolios to counteract stock market losses. Advisors use a combination of short-term (under 5-year maturities), medium-term (5–9 year maturities), and long-term (10+ year maturities) bonds for this purpose. In 2018, most bonds have not provided the portfolio protection that investors have traditionally expected, until very recently.

When bonds protect you from falling stock prices

1) When the economy goes into a recession

The Federal Reserve cuts interest rates to stimulate economic growth. When rates go down, bond prices go up.

Example: During the market downturn in 2008, the stock market was down 36% but 10-year Treasuries were up 20%, and the Federal Reserve acted aggressively to lower interest rates.

2) In periods of global uncertainty

People sell other investments to buy US Treasury bonds because they're considered the safest investments in the world. When demand for Treasury bonds increases, prices go up.

Example: The recent fear of an unstable Italian government negatively affecting Italian debt repayment and European economic growth caused investors to sell stocks and buy US Treasury bonds.

3) In a deflationary environment

With deflation, future prices of goods and services are expected to go down, so your fixed bond coupon will buy you more. As interest rates go down, bond prices go up.

Example: In the early 1930s, during the Great Depression, annual returns for stocks went down between 9% and 44% each year while 10-year Treasuries went up between 2% and 9%.

When bonds do NOT protect you from falling stock prices

When there are inflationary fears

Inflation fears cause interest rates to go up and therefore bond prices to go down. Your fixed bond coupon will buy fewer goods and services in an inflationary environment.

Example: On February 26, 2018, signs of wage inflation caused investors to sell bonds, making prices go down. The S&P 500 went down 10% over the next few days.

When bonds can hurt you in an up stock market

No-growth economy and inflation (stagflation)

Inflation causes rates to go up and bond prices to go down. Your fixed bond coupon can't keep up with the increased prices of goods and services. But stock prices may still increase because companies benefit from their ability to charge customers higher prices.

Example: In 1980, GDP growth was -0.2% and inflation hit 13.29%. The stock market returned 31.74%, well above the inflation rate. But 10-year Treasury bond returns were -2.99%, which meant investors lost money two ways: 13% lower purchasing power due to inflation, and actual negative bond returns.

What do we expect for the rest of 2018?

Despite the recent move to slightly lower rates, the underlying contributors to higher interest rates aren't going away anytime soon (see our blog, March 22, 2018):

• The Federal Reserve's commitment to raising interest rates
• The Federal Reserve's shift away from buying Treasuries and mortgage-backed securities
• International tariffs raising the prices of goods
• Rising commodity prices (how much is it costing you to fill your gas tank?)
• Wage growth
• Larger borrowing needs by the U.S. government and corporations

What you can do

If you're worried about negative bond performance due to rising interest rates but still want some protection from falling stock prices: take money out of medium and longer-term bonds and invest in money market funds and very short-term notes (under 2-year maturities).

Currently, money market funds are yielding about 1.75% and 2-year Treasuries are yielding 2.47%. While the yields on these very short-term bonds and money market funds are lower than medium and long-term bonds, they still keep up with reported inflation.

The bottom line: reduce potentially significant price risk on your medium and long bonds in exchange for slightly lower income (½% to 1% lower yield).

Please keep in mind, the right investment strategy depends on your overall personal financial situation. We welcome the opportunity to evaluate your specific situation alongside you.

A bond is a fixed income investment in which you lend money to an entity for a specified period of time, and in return, you receive interest payments based on the bond's stated coupon. You can own a government bond or US Treasury (lend money to the government), a municipal bond (lend money to a municipality like a city), or a corporate bond (lend money to a company).