It’s the Bonds

It’s a strange time for investors in diversified portfolios. While stock markets have had their ups and downs, the overall return of the S&P as of 9/30 was a solid 11.68%.

So, why are so many portfolios flat or down then? This time, it’s the bonds.

There is a saying in financial advisor circles that a “bad year in bonds is like a bad day in stocks”.

Well, this year is certainly different. According to Niall Ferguson in Bloomberg Opinion:

 "In terms of total returns, this is the biggest bond market rout in 150 years. Last year was in fact US bond investors’ worst year since 1871, with a total return of minus 15.7%, even worse than the annus horribilis of 2009. For 2023, the year-to-date return has been almost minus 10%; annualized, that’s minus 17.3% — even worse than 2022. We are looking at bond investors’ two worst years in a century and a half."

At a time like this, it feels like a good time to explain the basics of bonds, why we recommend them as an asset class for our clients, why performance has been unusually volatile, and what we are doing to adjust portfolios to current market conditions.

Bond Basics

Governments and companies issue bonds to raise money to fund projects or operations. Investors are essentially loaning money to the issuer, who pays them back when the bond matures, along with interest along the way. As a result, bond prices have a strong relationship to interest rates, and prices fall when rates go up and vice-versa. The interest payments (dividends) also make them attractive to people interested in regular income from their investments, including retirees.

Bonds are generally considered more conservative investments than stocks. However, all investments have risk, and bond issuers could default on their loans and not pay their bond holders.

Additionally, bonds are typically issued on specific dates and in “chunks” of $10,000 or 1,000, making it less attractive for casual investors to own individual bonds. Individuals typically buy bond “exposure” though mutual funds or exchange-traded funds (ETFs). The fund managers have expertise in researching the company (or municipality) who issues the bonds, and enough funds to achieve diversification by buying many bonds from multiple issuers.

Why Now

We include bond funds in our portfolios to address multiple goals:

• Reduce Volatility. Bonds are (usually) much less volatile than stocks.

• Generate Income. Bonds (typically) pay dividends to their investors.

• Diversification. Historically, when stock markets zig, bonds will zag (and vice versa)

Interest rates have risen steeply and quickly. This has caused bond prices to fall precipitously. Think about it – if you offer to pay someone 3% interest while your neighbor offers 6%, no one will want your “bond” offer, and it becomes less valuable.

What We Can Do

Our goals related to bond allocations haven’t changed. We still want to reduce portfolio volatility, generate income and diversify. However, we have tools to achieve these goals through other methods. These include:

• Reducing Bond Duration. Duration is simply the time between now and the maturity date of the bond. The shorter the duration of the bond, the lower the general volatility of the price. For example, the price of a bond that will mature in six months is not going to change very much in that time, but the price of a bond that matures in 20 years might fluctuate quite a bit. We’ve been shifting our bond funds from medium to short duration to reduce the volatility of our portfolios. The shortest duration funds are typically money market funds.

• Individual Bonds (rather than funds). At Cultivating Wealth, we have access to individual bonds but typically buy funds to avoid concentration in a particular bond for our clients. We also have access to fund managers, who (for a fee) can research and manage bond portfolios. This service is more cost-effective now that interest rates are higher, and something we are investigating.

• Dividend-Paying Stocks. For investors interested in income, replacing a portion of our fixed income allocation with dividend-paying stocks can be an option.

• Alternative Asset Classes. We are considering adding a small commodity allocation to portfolios and may consider real estate investments in future.

Keep Thinking Long-Term

Of course, now that bond prices have fallen substantially, it may be a good time to buy. Buying a bond at a discounted price means you will receive more than what you paid when it matures. Rebalancing accounts when bond prices have fallen will result in buying more of those funds at different (often lower) prices.

We expect to maintain a bond allocation in most client portfolios, but we will be making adjustments as described above. For clients with losses in taxable accounts, we will also be considering tax-loss harvesting before the end of the year.

This article is for educational purposes only and should not be considered investment advice. Speak to a financial advisor for advice on your personal situation.