Telemus Weekly Market Review January 10th - January 14th, 2022

Why Bonds?

For the past forty years U.S. bonds have been in a strong bull market. The interest rate on the 10-year Treasury peaked at just under 16% in 1982 and had fallen to its pandemic low of 0.52% in July of 2020. All indications are that 2022 may very well mark the start of a rising rate cycle. During 2021 we saw higher rates among intermediate and long-term bonds. Based on indications out of the Fed, shorter term yields are likely to follow in 2022. Since bond prices move opposite of interest rates, this has led to some rightfully questioning the role and necessity for bonds in a diversified portfolio.

We recognize in an environment where interest rates are on the rise that bonds are going to be challenged to keep up with the 7.4% average annualized return they’ve garnered since 1982ⁱ. Even though returns may be lower, it doesn’t necessarily mean one should not own bonds. However, what’s worked in the past may not always work in the future. Given that we may be in a rising rate cycle, it’s a valid question to consider.

Let’s start this analysis by first recognizing why investors own bonds: income and diversification. For clients with shorter investment horizons or income needs, they may be owning bonds more for the income return they are able to receive. Alternatively, longer term investors own some percentage of their portfolio in bonds to help provide diversification to the much more volatile returns of stocks. Today, income for bonds is low. The broad bond market, as measured by the Bloomberg Barclay’s U.S. Aggregate index, yields 2.0%. This offers limited yield for income hungry investors. From a diversification standpoint, given the low level of nominal yields bonds have only a certain amount of upside potential. With the 10-year Treasury at close to 1.75%, yields can only fall by this amount before hitting zero. While yields on bonds in other countries have turned negative, the Fed has expressed a desire to keep yields from going negative, so we assume the so called effective lower bound of 0% interest rates will hold. Thus, with a maximum downside to bond yields, this results in less upside potential to bond prices, and hence a lower level of diversification than may have transpired in the past when the level of rates was higher.

If an investor doesn’t like the fact that there is less income and diversification, what are their alternatives? First, one could just own all stocks, which would mean taking on much more risk, something that many may not be able to or willing to accept in a severe drawdown like what transpired in early 2020. Second, you could sell bonds and move to cash. That would reduce risk. However, there is currently little to no yield to cash, so even the meager income you get from bonds would migrate to nothing. Second, while cash would hold its value in a downturn, it would not provide any upside potential like you might see out of longer-term bonds (more on this later). More complex solutions like buying out of the money put options, which would pay off in providing downside protection if markets declined by a certain amount. However, academic studies have shown these strategies tend to lose money over the long-term as the premiums paid to own these options can add up over time. Hence for this strategy to be successful, you need to be able to effectively time the drawdowns and not lose too much on premiums along the way. Lastly, owning diversifying alternatives is a potential solution, although they experience negative returns during market pullbacks, although often to a lower degree than stocks. In the end, while bonds may not appear as attractive as they may have in the past, the alternatives aren’t perfect solutions either.

One aspect of bonds that can be appealing is the ability for bonds, particularly longer maturity bonds, to add value during equity market drawdowns. Not all market downturns are driven by changes in the economy, but the more significant ones often are. When the economy slows, expectations change toward easier monetary policies and this gets quickly reflected in intermediate and long-term bond yields. Case in point, between January 1, 2020 and March 9, 2020 the yield on the 10-year Treasury fell from 1.92% to 0.55%. This resulted in a 14% gain for the 10-year Treasury. In environment where stock prices fell, having a component of your portfolio in positive returning longer dated bonds, like a 10-year Treasury, proved to be a meaningful tool to sooth the impact.

As we look ahead it seems reasonable that the Federal Reserve can only raise rates so far before meaningfully impacting the ability of businesses to borrower, consumers’ ability to afford a mortgage, and government budgets becoming strained by higher debt service costs. As such, while we see a tightening cycle ahead of us, unless inflation gets too far out of control, we continue to expect that interest rates will remain range bound. Therefore, as yields rise, we become that much closer toward the top end of the range. All the while, the income received out of bonds is greater and the diversification properties improve. In the interim, it would be incorrect to characterize all bonds with the same stroke of the brush. There are opportunities to stem or reduce the impact of rising interest rates, including seeking a yield advantage through sector and individual bond selection decisions, and reducing interest risk by owning shorter maturities.

Over the long term, a balanced portfolio of stocks and bonds has been a prudent means for investors to weather varying market environments. We acknowledge that bond returns are likely to be below their long-term averages, at least for the near-term. After checking our own biases at the door and doing our research, we continue to believe a balanced mix of stocks and bonds remains a prudent core allocation versus alternative solutions.