Recently financial commentators have described bonds as not a “safe” investment. However, it’s all relative. If they mean that it’s not safe from losses, then sure it’s not a safe investment. Almost any investment that has expectations for a positive return has the potential for loss. More often than not though bonds have been compared to stocks, and bonds as a whole are certainly safer than stocks.
The reason that bonds are no longer considered “safe,” they argue, is that the 30 year bull market for bonds is over and as interest rates rise, bonds lose money. While it is true that rising interest rates are bad for bond appreciation, the losses are only temporary. As bonds mature new bonds can be purchased at the prevailing higher interest rates. Thus, any losses from falling bond prices are eventually replaced by gains from higher yielding bonds.
The primary purpose of maintaining an allocation to bonds is capital preservation as a balance against equities which are more volatile. If an investor looks to move away from their target portfolio allocation, moving a higher percentage to stocks or cash than bonds simply because bonds look like they could lose more in the short term, than the investor is just engaging in market timing.
A move to stocks (even those perceived to be undervalued) can then have significant negative consequences. Since 1926 the worst 1 year period for a 5 year Treasury bond (a proxy for a high quality and short to intermediate term bond portfolio) has been a -5.55% return. However, for US stocks the worst 1 year performance has been -67.57%. Over a 3 year time frame, since 1926, the worst performance a 5 year Treasury bond has seen is a mere -0.41% annualized, whereas the US stock market has plummeted 42.35% a year over its worst three years.
A move to cash could be costly as well. While safer, a move from bonds to cash assumes an investor would know precisely when to sell their bonds and precisely when to buy them back. Such efforts to time the markets consistently cost investors – both in terms of unnecessary transaction costs and lower yields.
We recognize that there certainly is potential for rising interest rates. In last month’s blog post we referenced what actions we take with clients’ bond portfolios in order to limit the effects of a rising rate environment.
Clearly, bonds can and have lost value. Over the past thirty years bonds have experienced appreciation that is unlikely to be seen over the next 30 years. However, they still serve a valuable function in an investment portfolio; providing stability. Equity can experience wild swings in value which makes a 3-6% loss in a market weight bond portfolio seem minuscule. One needs to look no further than recent examples like in 2008-2009 when global stocks lost 48.16%, or more recently the month of August in 2011 when global stocks fell 16.30%.
If you see financial pundits saying how bonds are not a “safe” investment and that you should direct your investments to safer stock positions or cash, it would be better to just change the channel and not your investment portfolio.
Index Performance June 2Q YTD Trl 1
US Stock (Russell 3000) -1.30% 2.69% 14.06% 21.46%
Foreign Stock (FTSE AW ex US) -4.27% -2.79% 0.20% 14.43%
Total US Bond Mkt. (BarCap Aggregate) -1.55% -2.32% -2.44% -0.69%
Short US Gov. Bonds (BarCap Gov 1-5 Yr) -0.38% -0.65% -0.49% -0.02%
Municipal Bonds (BarCap 1-10yr Muni) -1.61% -1.83% -1.34% 0.34%
Cash (ML 3Month T-Bill) 0.01% 0.02% 0.04% 0.11%
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