Are Bonds Still A Good Bet?

Third Quarter Newsletter – 2019

With bond yields near generational lows, it raises the question: is it still worth owning bonds? Given the risk-return offered, are bonds still prudent for long-term investors within a broadly diversified portfolio?

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Are Bonds Still a Good Bet?

With bond yields near generational lows, it raises the question: is it still worth owning bonds? Given the risk-return offered, are bonds still prudent for long-term investors within a broadly diversified portfolio?

For most client portfolios, bonds provide “ballast” helping to stabilize the generally more volatile returns from stocks. Historically, bond returns have been lower than equity returns, but bond price movements (especially Treasury bonds) can be counter-cyclical to stocks. When stocks slump, Treasury bonds often increase in value.

Both the coupon payment (i.e., interest paid to the bondholder) and any change in value contribute to a bond’s total return. If you hold a bond to maturity, your principal is returned, and the total return is simply the interest paid during the life of the bond (barring a default). But over a bond’s life, it’s value will fluctuate with market conditions, the credit worthiness of the issuers, and the prevailing interest rates. The value of a fixed-rate bond decreases as interest rates rise (and increases when interest rates fall).

With the current low rates there is the potential of a significant rise in interest rates which would reduce the value of bonds—the supposedly more stable part of your portfolio.

A Historical Look

Long-term Treasury bonds were yielding over 15% back in the early-1980s. Since then yields have declined fairly steadily to the current yield of around 2%. Inflation has also declined along the way, so the change in real return has not been nearly as great. Still it is a very different investment proposition investing today at a 2% yield as compared to even investing a decade ago.

Source: Board of Governors of the Federal Reserve System; fred.stlouisfed.org

 

Current Yields

Looking at representative bond funds from our model portfolios, we see yields clustered around the 2% mark. With corporate bonds yielding slightly more and intermediate-term Treasurys yielding a little less.

 

Fund 30-day SEC Yield
Vanguard Total Bond Market Index 2.3%
Vanguard Inter-Term Investment-Grade 2.5%
Vanguard Intermediate-Term Treasury 1.6%
PIMCO Int’l Bond Fund (U.S. Dollar-Hedged) I 1.5%

As of 9/30/2019; Source: Vanguard and PIMCO websites.

 

What To Do

The counterargument is that Treasury bond yields in the United States are still higher than some other developed countries. Japan and Germany (among others) have negative interest rates. Hence, there is the potential for a meaningful increase in bond values if Treasury yields continue to fall (or potentially even turn negative).

At Denny Park Investments we are sticking with our long-term allocation to bonds for now. Our models already tilt toward shorter maturity bonds which should help somewhat protect client portfolios from unexpected increases in interest rates. By keeping our average bond duration lower, the potential change in value from interest rate movement is damped compared to holding long-term Treasury bonds or other long-term debt.

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