Role of Bonds in a Portfolio
Historically, we have used bonds in a portfolio to offset the risk of stock investments as they have exhibited a very low correlation to stock returns over time. This means that when stocks “zig,” bonds often “zag.” However, with the recent uncertainty surrounding the high inflation numbers and the conflict in Ukraine, we have witnessed negative returns in both bonds and stocks over the quarter.
A major factor causing weaknesses in both stocks and bonds is related to the rising interest environment. As can be seen in this quarter’s market summary, interest rates have risen over the past quarter. This is due to the Fed raising its short-term rates and the market’s expectation of future interest rates. The market is demanding higher future yields, given the recent doubt in the health of the economy.
One thing to keep in mind as this rate environment unfolds, is that bonds are structurally different from stocks. Where stocks represent ownership of companies, their values tend to grow when prospects are bright, and decrease when the future is uncertain.
On the other hand, bonds are more akin to loans where the borrower has a future promise to pay back principal owed at some point in the future (typically with interest payments along the way). Therefore, although the recent returns of bonds are disheartening, it creates a situation where investors should expect a higher return (due to higher yields) from bonds going forward. As bonds mature, the proceeds are reinvested into the higher rate environment.
For example, the following is a chart of the market yield of a 1-year Treasury bond over the last year:
Although the graph is small, the rate that an investor should have expected to earn on a 1-year bond, purchased on 3/31/2021 would been approximately 0.07% for the next year. If the investor reinvested into another 1-year bond when they were paid back on 3/31/2022, we would expect them to be able to earn 1.63% over the coming year, which is where rates were at the end of the period.
It should also be acknowledged that bond funds we hold in portfolios are just a diversified way to get exposure to many bonds at a low cost. As these bonds mature, they are reinvested at the prevailing interest rates. Of course, future bond returns will also depend on where interest rates go from here and there may be more pricing pressure ahead. At the same time, for long-term investors we believe this rise in rates increases the long-term expected return of bonds as an asset class moving forward.