What About Bonds?

Bonds will be a terrible investment over the next 10 years.  That is the conventional wisdom in the investment community lately.

“Bonds are the worst asset class for investors,” says Professor Burton Malkiel, the author of A Random Walk Down Wall Street, in an opinion piece published in late March in The Wall Street Journal.  “Usually thought of as the safest of investments, they are anything but safe today.  At a yield of 2.25%, the 10-year U.S. Treasury note is a sure loser.”

This prediction may or may not be correct; however it is important to review the reasons why investors should hold bonds in a diversified portfolio.

What Are The Risks of Owning Bonds?
There are 3 components of risk in owning bonds.  Issuers of bonds (corporate or government) can default and not repay you.  Default risk can be very low (U.S. Treasuries) or quite high (corporate junk bonds).  As interest rates rise, the market value of your bond holdings will go down (interest rate risk).  Over the past ten years bond returns have been very good due in large part to the increase in market value as rates went lower and lower.  Inflation is a source of risk that greatly impacts an investor’s purchasing power in retirement.  For retired investors, interest and dividends are an important source of income.  If inflation outpaces interest rates, the bond investor’s purchasing power decreases.

It is likely that bond returns will not be nearly as good as they have been over the past ten years.  So what should an investor do about it?

1. Sell bonds and move into cash or CDs, waiting for interest rates to rise.
   While it seems like a good strategy, it’s very difficult to predict when rates will rise.  They may stay low for several more years.  Inflation is likely to outpace interest payments from cash reducing their real value and purchasing power.
2. Sell bonds and re-invest in the stock market.
   In addition to expected return, high quality government bonds are a low-risk way to diversify a stock portfolio.  An investor would greatly increase portfolio risk using this strategy.  Ask yourself if you can stomach the volatility of a 100% stock portfolio during a period like 2008.  Most investors would be unable to ride out that storm.
3. Reach for higher dividends by reallocating to longer-term or corporate bonds.
   This strategy will also increase risk in a portfolio.  Longer-term bonds are more volatile and sensitive to interest rate changes.  Corporate bonds increase default risk if the business offering the bond fails.
4. Do nothing.
   Bonds are in a portfolio for good and valid reasons.  Over the long term, interest income – and the reinvestment of that income – accounts for the largest portion of total returns for many bond funds.  The impact of price fluctuations can be more than offset by staying invested and reinvesting income, even if the future is similar to the rising-rate environment of the late 1970s and early 1980s.

I don’t recommend selling bonds and buying either cash or stocks.  However, there is merit in adding longer-term Treasury Inflation-Protected Securities, or TIPS, and short-term corporate bonds into a portfolio for investors willing to accept the additional risk.  There is no way to reliably predict future interest rates or inflation, so most investors will fare very well by leaving their bond allocation alone and riding out the market cycle.