October 2017 Comments: Bond Investments

Victor Levinson Comments

Last month we changed our focus from the surprising, ongoing advance of stock prices since the 2016 election, to bonds, the other major asset class in most client portfolios.

During September there was a substantial increase in market interest rates, which brought the benchmark ten-year US Treasury yield to 2.34%, up 21 bps from August’s close of 2.13%. October’s increase was a much more modest 4 bps, to 2.38%, still below the year end 2016 rate of 2.45%, even as the Federal Reserve has made two 25 bps increases (in March and June) in the ultra-short term overnight rates it controls during 2017.

Ordinarily, an increase in rates by the Fed would result in a similar increase in longer-term rates set by bond market buying and selling. Surprisingly, this has not occurred so far in 2017.  A new Fed Chairman replacing Janet Yellen, and a likely additional 25 bps short term rate increase by the Fed in December, provide some additional context to this discussion.

We are going to use Jeff Sommer’s recent article on bonds (NY Times, 10/29/17 Sunday Business, page 3) as background for our Comments.

The article observes, as we often do, that “Stocks and bonds are complementary partners in standard portfolios. While stocks typically have a higher return potential, bonds are generally less risky and provide a hedge against a stock market plunge, as they did during the bear market that started in 2007.”

PPA’s addition: the extent of the stock decline (and subsequent recovery) are most noteworthy, and add important detail to the rather bland statement of a “bear market that started in 2007.” The S&P 500 index declined from its October 2007 high of 1,565 to a March 2009 low of 677, a decline of 57%. That same index closed October 2017 at 2,575, a gain from low to high of 280%. This is an annualized gain of approximately 17% over the 8.5-year period.

The article continues that “despite a rocky bond market over the last month, bond prices are still too high, and their yields so low, that bonds simply can’t provide much buffering.”

PPA’s addition: we respectfully disagree. If long term market history is any guide, when stock prices fall 20% (the definition of a bear market), or more, the declines in bond prices attributable to rising interest rates are likely to be much, much smaller, and that is the whole point of owning an appropriately allocated and diversified portfolio of bonds and stocks.

The article then continues with a discussion of the wonderful returns in stocks over the last eight plus years, and whether they are likely to continue.

PPA’s addition: surely no one knows the answer to this question.

The article then returns to another recent article by the author: “the standard practice after a big run up in stocks is to rebalance, meaning to take profits out of stocks and put them into bonds. The goal is to create a well-diversified portfolio … the problem is that this is not an ideal moment to be putting money into bonds.” Reasons for the continuing upward pressure in interest rates are presented, ranging from the Fed’s desire to raise rates gradually to ward off future inflation, to the Fed program of selling bonds it had purchased in the aftermath of the financial crisis, to the identity and likely policies of the new Fed chairman, to the potential inflationary impact of the larger budget deficits coming from the government, including from possible changes in the tax law.

Sommer continues that “the bond market turmoil leaves investors in a bit of a muddle. The central reason for holding bonds remains intact: Bonds will still buffer a portfolio and generate income. But in the near future, they aren’t likely to do so as effectively as in the past.”

PPA’s addition: if the point of bonds is to offer a buffer against serious stock market declines, investors should focus on this purpose, and be less concerned about whether this is or is not a good time to buy bonds based on their future return potential.

The Sommer article concludes with some observations from John Bogle, the founder of Vanguard, one of which is that “compared to stocks, bonds are a good value, better than they have been in years … and it still makes sense to hold stocks and bonds in a diversified portfolio.”

PPA’s addition: we take no position on the relative valuations of bonds and stocks, but certainly agree that a diversified portfolio of stocks and bonds, allocated to the investment goals and risk tolerance of each investor, is the best defense against the unexpected (refer to Larry Swedroe’s observations about asset allocation above).

A few other comments may prove useful:

  1. Rebalancing (adding to bonds after large stock price advances) “is more a risk control measure than a return generator.” (This quote comes from Sommer’s article on rebalancing, and we agree. Note there is no mention in the quote of whether this is a good or bad time to own bonds, just that owning them is intended to provide risk control.)
  2. Investors expect to receive higher interest rates on their bond investments when inflation rises, to offset the reduced purchasing power of the money they receive when their bond investments mature. So when rates do rise, and bond prices decline, one other result is that investors receive higher interest payments in the future.
  3. The extent of price declines depends on maturities of the bonds, and on the amounts and time intervals of the interest rate increases.
  4. We are always available to discuss these issues in more detail, including how to balance stock and bond allocations in each client’s portfolio.