Bonds! What are they good for?
Markus Muhs - Oct 09, 2018
My self-inflicted homework this Thanksgiving long weekend is to write an incredibly boring – but necessary – blog post about bonds. Why do we invest in ‘em? Why have they done so badly of late? Is there any point investing in them for the future?
Just this past week I had the pleasure of meeting PIMCO’s Alfred Murata in person, here in Edmonton. Newport Beach based Pacific Investment Management Company (PIMCO) manages around $1.8 trillion of mostly bond/income assets, probably making them the biggest active bond/income managers in the world. PIMCO has become so big in their field that it is said that often when the governments of small countries issue new bonds, they straight up get bought up by PIMCO before entering the open market.
Murata presented on what they’ve been doing in the PIMCO Monthly Income Fund, now the third largest bond/income fund in Canada with around $16 billion AUM, running a similar mandate to the $113B US PIMCO Income Fund. Not to bore you with all the details, the words that explained it all were that 2018 has been the worst year for bonds in over 30 years. The fact that their year to date loss on the F-class version of the fund (to end of Sept 2018) was -0.31% is actually cause for celebration, given that the funds in the number 1 and 2 spots (managed by the fund arms of each of Canada’s two biggest banks) had losses more than twice that year to date.
Obviously, stock investors have seen much worse than losses of less than 1%, but bonds and bond funds/ETFs present an interesting conundrum in a portfolio. There’s usually little upside to them, and while we own this boring, supposedly “safe” asset class we hate to see even minor losses, and instead expect a steady interest return on them.
Why are my bond funds going down?
To make this blog post a handy future reference I can share with my clients whenever that question comes up, here are some of the bond basics.
A basic bond (setting aside floating rate bonds and all sorts of other nifty products out there) carries a principal value or book value (that will be repaid at maturity), a coupon rate (percentage of book value that’s paid annually in interest), a term to maturity or maturity date, and a credit rating. Based on what those four factors are and what prevailing markets are (the going rate for equivalent bonds), a market price for the bond and a yield to maturity are derived.
An example of provincial bond offerings available around the time of writing this. Note how the lower (A+) rated, lower-coupon Alberta bond at the bottom sells for around 4% cheaper than the higher rated, higher-coupon Quebec bond right above it. The YTM column though has both yielding about the same, with a slightly higher rate compensating for Alberta’s slightly lower credit-rating.
A lot of people better understand an analogy to GICs. Let’s say you buy a 5-year GIC one year at 3%. A year passes and interest rates go up; now a 4-year GIC pays 4%. You’re still locked into your GIC that has 4 years left on it at 3%, so all you can do is kick yourself, and you’ll kick yourself even more if next year a 3-year GIC pays 4.5%. Bonds can be bought and sold between their issue date and maturity date, so they trade on a somewhat open market and are priced ultimately for fairness. If you could sell that GIC with 4 years left on it, you’d have to sell it at a discount to its maturity value, so that the person buying it off you themselves can get a 4% yield to maturity (combination of the 3% your GIC pays plus appreciation from the discount they bought it off you to when it matures).
In summation, if you hold a portfolio of GICs, it doesn’t fluctuate at all. You just wait for them to mature and hope for better rates on maturity. If you hold a portfolio of bonds, it fluctuates daily with changing market conditions. In addition to changing interest rates, your bonds can also change value as the credit-worthiness of the issuer changes.
Rising interest rates cause the values of bonds to drop. Falling rates cause their values to rise.
What’s been happening with interest rates?
To answer this question, let’s look at the very long-term and then the shorter term.
Source: Wikimedia public domain
Over the very long term, from the early 1980s to present, we’ve seen a more-or-less steady drop in interest rates. Rates were jacked up massively in the late 1970s to respond to out of control inflation, causing (at that time) a massive slump in bond values, and in the time since those rates have gradually gone down.
In Canada, we saw 5-year government bonds go from over 18% in 1981 into the single digits by 1992, to below 5% in the early 2000s, to below 3% for much of the past 10 years post-credit crisis. The 10-year is usually what we look at to benchmark long(ish) term bond rates, but I use the 5-year here because it’s more akin to 5-year mortgage or GIC rates that we remember, which often fluctuate alongside government bond rates. Some people remember renewing 5-year GICs at over 5% (and in my bank days I remember many stubbornly holding out when rates dropped, expecting them to rise back up over 5% in just a year or two). Unfortunately, many of us will also probably be unprepared for the fact that 5-year mortgage rates over 5 or 6% are more the norm, with 3% being the exception, so hold on tight Toronto condo market!
This long, protracted drop in rates has created a secular bull market in bonds that has lasted almost 40 years but is finally, probably, coming to an end.
Looking at the 10-year U.S. Treasury that’s in the news so much of late and causing all sorts of consternation for the markets, the 10-year yield bottomed in the summer of 2016, spiked upon Trump’s election (with the changed expectation of higher rates quicker) and just recently broke above 3% again, to rates we haven’t seen since 2011.
Source: chart made myself on Excel with numbers publicly available
What the above chart also shows is that it’s been kind of stop and go the last decade. Ever since the bottom of the recession – when central banks all over and in particular in the U.S. injected mass quantitative easing (lower rates) – people have been expecting rates to rise again. As the economy sputtered in 2010, again in 2011, and again in 2015, those higher rates never came to fruition and we see the 10yr dropping each time. Now though, maybe the economy really is shooting on all cylinders, inflation will come back, and the U.S. Federal Reserve will have no choice but to continue raising rates?
Getting back to how rates affect bonds, a concept at play here that most finance and investing courses get more in-depth into, is duration. Duration is the measure of how sensitive bonds are to rising or lowering rates. Again, not to get overly complicated here, in short, the lower a bond’s interest rate and the longer it’s term to maturity, the higher its duration and thus the more it drops when rates rise.
Rates are/were very low to begin with, making bonds uber-sensitive. On top of that, if you owned a fund that was heavier in longer-term stuff than shorter-term, it got hit harder. The iShares U.S. 20+ year Treasuries ETF (TLT) went down over 14% in the time from July 2016 to present (that’s total return, including reinvested interest, courtesy of Morningstar). The more moderate-term 3-7 year equivalent ETF (IEI) meanwhile is only down around 4-5% over that period.
All that said, if you only own individual bonds that mature when you actually need the money, the fluctuation in values shouldn't matter. If you buy the above Alberta bond today and hold it until maturity in December 2022 your yield to maturity will be 2.7% regardless of what the markets do. If rates drop and/or if the next government repairs our province’s damaged credit rating, you could see an extra gain if you sell it before maturity.
Why invest in bonds at all?
This is the other major point I want to get across in this boring blog post about bonds, and sorry for taking so long to cut to the chase; some of you reading this don’t even need to invest in bonds at all! The above question being: with all we know about bonds and how they react, given that interest rates are still very low by historical comparison, and more likely to go up than down, why invest in them at all?
It all comes down to two things: 1) modern portfolio theory, 2) we don’t have a clue what’s going to happen in the future.
The idea of owning a portfolio of assets, instead of investing all your money into just one thing, is to own different things that go up and down at different times, so that at the end of the day we can sleep at night knowing our portfolio is mostly just going to fluctuate within our own personal comfort range. The combining of investments into a portfolio that have low correlations with one another yields a portfolio that is less volatile.
Bonds tend to perform well when economic conditions are less favorable, when interest rates are dropping and a “flight to safety” sees money shifting out of equities and into bonds (especially U.S. Treasuries). As such, they pair up well with equities, which tend to do the opposite. They do sometimes go up and down at the same time, but over most of history, stocks and bonds have had pretty low to slightly negative correlations with one another.
Whenever you engage in an investment strategy with an advisor, you’ll generally have your risk tolerance, objectives and time horizon assessed. An asset allocation is then usually recommended that fits that time horizon and your personal tolerance to risk.
If we look to history as a guide, through the past 100 or so years of returns for various asset allocations, what we’ve found is that over periods of time of 30 years or longer, stocks with dividends reinvested have beaten every other asset class hands down. Yes, this means that if you had the misfortune of investing all your money only on one day, at the market high in 1929, and simply reinvested all dividends from that day forward, by 1959 you would have made a better return than if you had stuck to government bonds throughout that period.
This means that if your investment time horizon is over 30 years, you don’t need bonds at all in your portfolio, with one caveat: provided you don’t freak out about your portfolio losing half of its value at least once during the ensuing 30 years, losing over 20% of its value between 6 and 10 times, and losing over 10% on average every year. If you can stomach that type of volatility and aren't prone to obliterating your long-term investment strategy out of fear of market volatility, then bonds will only have the effect of detracting from your returns and have no place in your portfolio.
If your time horizon is less than 30 years, then some allocation to bonds may be necessary. Even if your time horizon is around 10 years, only a well-diversified portfolio of 60% stocks to 40% bonds will finish at least flat in the worst of decades.
Taking this one step further, in retirement you might consider that your time horizon is 20-30 years or more, and you don’t really need that much of an allocation to bonds. Here another risk comes into play: sequence of returns, which is something I’ll get into more another day. In short, too much fluctuation in returns year to year can be severely detrimental to a retirement income plan, so you should still have some allocation to bonds.
Getting on to point 2: the other reason we invest in bonds is because we don’t really KNOW for sure that things will pan out the way we expect them to. Yes, it’s likely rates will continue to rise and there’ll probably be another year or more before we hit a recession again and see rates dropping. But everything might also blow up in our faces tomorrow; we can’t predict the future.
Remember what I mentioned earlier about duration and the sensitivity of low-coupon bonds to interest rate changes? Well, the same applies both ways. The 10-year going from 3% to 3.25% took a chunk out of bond values; if it went down from 3.25% back to 3% or lower, it could mean a significant appreciation in bond values. Given that such a scenario would probably only unfold if something unexpectedly went wrong with the economy, you’re going to want that appreciation in bond values to offset the fall in stock prices.
When I first started financial planning, my software used as a long-term estimate of bond returns a number in the 6-7% range. This was in 2008, and that was the type of bond return we were getting accustomed to. Literally, for decades we could rely on not only collecting nice high interest coupons from our bonds or bond funds, but also seeing a bit of capital gains as interest rates steadily declined. Not likely in the future.
I mentioned that we have no crystal ball to see into the future, what will happen with the economy, when the dreaded (but inevitable!) recession finally hits. Best case scenario things go well for years and years into the future, stocks continue to do well, and bonds provide absolutely zilch in net returns. The cost to our overall returns, of holding those bonds, is the cost of downside protection on our portfolios.
If you have a very long time horizon and feel you have absolutely no need for downside protection – and most importantly can keep your emotions in check – then you could steer clear of bonds.
If you want some degree of downside protection to an otherwise aggressive portfolio (ie: an 80% stock to 20% bonds portfolio), keep in mind that it doesn’t do you any good to be defensive on those bonds. In other words, don’t put your 20% into short-term or corporate bonds that’ll have a higher correlation with stocks. That’s not why you’re owning them, and it won’t have the effect of off-setting stock losses.
If your portfolio has a fairly significant (40%+) allocation to bonds, then it’s important that you treat diversification of your bond portfolio with the same diligence as with the stock side of your portfolio. Simply owning one aggregate bond fund for your income allocation won’t do you any good and you should expect such a bond fund in bad years to potentially be down 5% or more.
This is where I come in, and can help you assess your portfolio, give you a second opinion on whether you have the right (ITALIC) kind of diversification. Feel free to contact me if you need help.
Bond image used at top is public domain, sourced from Wikimedia Commons