Last week I started a conversation with you about bonds. Given the attention bonds are currently receiving, I wouldn’t be surprised if we revisited this topic through the rest of the year. And given the size of the bond market, we should be spending time on it. The US bond market is three times the size of the US equity market, and the global bond market is over $90 trillion.
First, a reminder about bonds: when interest rates rise, bond prices fall, as they are inversely related. In American history, the largest interest rate increase was in the late 1970s to early 1980s. During that time, however, bonds did not have a year with a negative total return. The worst year on record for bonds was actually 1994, with a total return of -2.92%.* I say that to add perspective to the discussion, as we all well remember 2008, when the stock market’s S&P 500 was down 37%.
For the bond investor, rising interest rates improve intermediate to long-term bond returns over time. That is because, over the long run, the bond investor’s returns come predominantly from the interest payment stream, not the change in bond price. As interest payments come in and maturing bonds are reinvested, a well-structured bond portfolio will reset to the new rate environment. There may be headwinds or modest declines in the short-term, but in the longer run the higher rates more than overcome these things. We may need to be patient for a couple of years to see the rewards of higher total returns; however, we believe greater long-term positive results are worth the wait.
At Covenant Trust Company, we build portfolios for the long-term investor, well-diversified and able to withstand the emotional “crisis-du-jour.” The “bond bubble” or “looming bond crash” is just the most recent example. My colleague Gary Johnson, Portfolio Manager, calls the market’s response to Ben Bernanke’s recent comments on the possible unwinding of QE3 a “hair-trigger response,” and an overreaction. CTC takes the view that the most probable scenario for bonds is a slow, gradual uptick in rates over a period of years, not months. In our opinion, the drivers of significant increases in bond yields, sustained inflationary forces, are not yet present in today’s economy.
For the vast majority of us, owning high quality bonds as a part of our portfolios can be the best diversifier of risk. We saw that clearly in 2008-2009 and the subsequent recovery. We believe our clients will continue to see the advantages of a well-diversified portfolio even in a period of rising interest rates.
As always, if you have any comments or questions on this matter, please feel free to leave a message below.
Ann P. Wiesbrock, CFP®
*Source: Johnson Investment Counsel