Unbreakable Bonds

Veterans of past conflicts, friends of many decades, siblings, and spouses are all prominent examples of unbreakable bonds. Unfortunately, for investors, bonds that we invest our hard-earned dollars into don’t share the same quality and do, in fact, experience times of poor returns. We can see this in last quarter’s performance, where intermediate term U.S. bonds were down 5.9%. It was the worst quarter since 1980 and has surprised some investors, especially those heavily invested in bonds.

The poor performance happened due to the Federal Reserve raising interest rates, continued expansion of the economy, and the price increases that have pushed inflation rates to multi-decade highs. As a result, the consensus among some investors is that bonds stink and they should sell now before it worsens.

Before we throw the baby out with the bathwater, we need to understand a few things about bonds, why they are still crucial to our portfolios and what insight we can gain from looking at how bonds behaved in similar situations in the past. The most obvious period for comparison is the late 1970s and early 1980s, during the last period of elevated inflation rates.

The first chart above details the amount of variability in returns during a year and highlights the best/worst returns of the year and where the year ended. There are 21 years where bonds spent some of the time during the year the down only to finish the year higher. Only four years did investors see returns negative for the entire year. As referenced before, in 1980, bonds were down 8.8% in the first quarter of the year but ended the year up 2.7%.

Investors may feel frustrated, and rightly so, because bonds have a reputation for lowering portfolio risk while still earning a modest amount of interest in return. Add to this frustration in the past 12 or so years when interest rates have been much lower than in previous decades, leaving some to question why they still own bonds. But what these investors must keep in mind is twofold. First, if you sell your bonds, what will you buy with those proceeds? When evaluating those options for a long-term portfolio, the only option is to increase stock exposure. While they may seem attractive right now, commodities and even digital assets pose their own set of unique risks, and are very volatile. These assets classes should be considered more as a speculation than a long-term core holding.

The second point to note is that if bond investors are frustrated with being down 5.9% in one quarter, a look at the chart above showing the variability of stocks helps put their relative risk in perspective. For example, stocks during the periods above suffered three quarters where performance was down 20%, the most recent occurring in the first quarter of 2020.

The initial knee-jerk reaction in times like this might be to make allocation adjustments to change the course of your investments. However, it would serve investors better to focus on the long-term goals of their plan rather than trying to time the market or remove bonds altogether in favor of stocks, which seem to be performing better. While they are not unbreakable, bonds will continue to be a source of stable income, which will grow over time should interest rates continue to rise. An investor trying to shift away from bonds into stocks after one of the worst quarters in 40 years may find themselves jumping form the frying pan and directly into the fire if equity markets move lower in the coming quarters.