Should Bonds still be part of your Portfolio?

Dear Mr. Market –

BondsWe are only a little over half way through this year yet you have already taken investors on a very interesting ride.  From posting impressive results through the first half of the year and then allowing volatility to enter the market through various headlines and worldwide economic news you’ve certainly kept us all on our toes.

As investors look at their portfolios and their performance results we have seen one alarming statistic over the last month and half.  In June alone individual investors took over $80 billion dollars out of their bond positions!  Investors moved out of their fixed income positions quickly due to rising interest rates and to chase the impressive returns that the equity markets have been posting.  Bonds are often treated as the ugly stepchild of investing but we find that they are typically not truly understood by the majority of investors.  Lets take a moment to get a better understanding on the basics of fixed income investing and more importantly how and why they have a place in your portfolio.

 Bonds/Fixed Income 101:

In their most basic form bonds are essentially a promise to repay money, with interest, on a certain date in the future.  Think of them as an IOU where the borrower is obligated to pay the lender (the investor) a specified amount of money at regular intervals and then to repay the principal amount at the bonds maturity date.  There are several different types of bonds available in today’s market, the following bullet points will focus on the most common ones:

 TYPES OF BONDS

  • U.S. Government Bonds – typically these consist of Treasury securities and positions issued by the Government National Mortgage Association (“Ginnie Mae’s”).  These bonds are backed by the full faith and credit of the U.S. Government and are usually considered to have low risk.
  • State and Local Governments – Municipal bonds are issued by state, county or city governments.  In most situations they are issued to finance and improve public projects such as schools, water plants and highway construction for example.  They can be categorized as either Revenue Bonds (paid for with revenue created from the project) or General Obligation (G.O. Bonds) bonds (backed by the credit and taxing authorization of the municipality).  Often, the interest payments are exempt of federal and in some cases state and local taxes.  The credit ratings of municipal bonds can vary drastically and it is important that investors research them carefully before purchasing.
  • Corporations – A Corporate Bond is a loan from an investor to an established corporation.  Companies will issue bonds to finance projects, expansion and acquisitions.  This is an option that many companies will utilize rather than issuing additional shares of stock.   The financial stability of the issuing company must be carefully evaluated when considering any purchase.

 KEY CHARACTERISTICS

  •  RiskAll investments carry some degree of risk.  A good rule of thumb is the higher the risk, the higher the return. Conversely, safer investments offer lower returns. There are a number of key variables that comprise the overall risk profile of a bond.
  •  Price The price you pay for a bond is based on a multiple of variables, including interest rates, supply and demand, liquidity, credit quality, maturity and tax status. Newly issued bonds normally sell at or close to par (100 percent of the face, or principal value). Bonds traded in the secondary market, however, fluctuate in price in response to changing interest rates, credit quality, supply and demand and general economic conditions. When the price of a bond increases above its face value, it is said to be selling at a premium. When a bond sells below face value, it is said to be selling at a discount.
  •  Interest RateBonds pay interest that is either fixed, floating or payable at maturity.  The majority of bonds have an interest rate that is fixed until maturity, these pay a percentage of the principal amount that is set when the bond is issued.  Floating rate bonds will reset periodically based on an index or benchmark such as Treasury Bills or the London Interbank Offered Rate (LIBOR).  Bonds that pay at maturity are called zero coupon bonds; they are sold at a discount and pay all of the interest accrued plus principal at maturity.
  •  Maturity A bond’s maturity refers to the specific future date on which the investor’s principal will be repaid. The maturity can vary, below is a brief explanation of the three most common terms:

Short-term:   maturities of up to 5 years

Medium-term:   maturities of 5 to 12 years

Long-term:   maturities greater than 12 years

  •  YieldA bond’s yield is the return earned on the bond, based on the price paid and the interest received. Usually, yield is quoted in basis points, or bps. One basis point is equal to one one-hundredth of a percentage point or 0.01%. For example, 5% = 500 bps.  For bonds that are purchased in the secondary market, at a premium or a discount, the yield to maturity will be different than the yield associated with the bond when it was issued based on the price that was paid.
  •  Call ProvisionSome bonds may have a call feature that allows or requires the issuer to redeem the bonds at a specified price and date before maturity. For example, an issuer may call a bond when interest rates have dropped significantly from the time the bond was issued. A call provision offers protection to the issuer; callable bonds usually offer a higher annual return than comparable non-callable bonds.
  •  Credit Quality, Ratings and DefaultThe array of credit quality choices available in the bond market ranges from the highest credit quality Treasury bonds, which are backed by the full faith and credit of the U.S. government, to bonds that are below investment-grade and considered speculative, such as bond issues by a start-up company or a company in danger of bankruptcy. Credit quality should be one of the most important elements when looking at a bond.  Moody’s Investors Service and Standard & Poor’s Corporation are the two leading agencies that rate bonds based on financial condition, management, economic and debt characteristics, and the specific revenue sources securing the bond. The highest ratings are AAA (S&P) and Aaa (Moody’s). Bonds rated in the BBB/Baa category or higher are considered investment-grade; bonds with lower ratings are considered speculative.

OK…so there is a brief overview on bonds but what does that all really mean to the average investor and do they really have a place in your portfolio?

As we see investors jumping out of fixed income and moving quickly into the equity Lemmingsmarkets we can’t help but shake our heads.  It paints the image of lemmings following each other as they run over the edge of a cliff; it is a classic definition of ‘herd mentality’.  Rather than making rash decisions investors need to realize what their individual goals are and what makes them unique compared to other investors.   It reminds us of the popular saying, “People don’t plan to fail, they simply fail to plan.”

 Do you have a plan?  What’s your asset allocation?  

 The basic element of any investment plan should be your Asset Allocation.  In its most simple form Asset Allocation is portfolio diversification.  It can reduce volatility and deliver more consistent returns if structured properly.  In its basic form it determines how a portfolio will be invested in equities, fixed income and cash.  The allocation of an investment portfolio over the long run is much more important than buying the next hot stock.  Research has shown that over 80% of a portfolio’s performance is driven by asset allocation and not by stock selection.  Let’s take a moment and put this in perspective.

If you owned little or no bonds in your portfolio in 2008 you had nothing to help buffer your portfolio from the -37% decline that the S&P 500 returned for that year.  While equities were slaughtered Treasury Bills (3 month) returned 1.59% and Treasury Bonds (10 year) posted an impressive 20.10% return!  Through 2008 as the equity markets struggled investors aggressively sold their stock positions and looked to move into bonds and/or cash positions only to see the market move against them again in 2009!  Look at the chart below to see how the markets worked against investors and crushed their savings and long-term plans as they chased returns from year to year.

Year

Stocks

T.Bills

T.Bonds

2008

-36.55%

1.59%

20.10%

2009

25.94%

0.14%

-11.12%

2010

14.82%

0.13%

8.46%

2011

2.07%

0.03%

16.04%

If investors had a disciplined Asset Allocation strategy in place they would have come out of that incredibly challenging market environment in much better shape!  Let’s take a look at how an investor with an allocation of 50% equity and 50% fixed income would have performed over the same time frame as compared to the S&P 500:

Year

50/50

S&P 500

2008

-17.94%

-37.00%

2009

16.34%

26.46%

2010

11.69%

15.06%

2011

5.28%

2.11%

2012

10.13%

16.00%

If you average the returns over the last 5 years the 50/50 allocation would have posted an average annual return of 5.1% while the S&P 500 (all stock) would have posted a return of 4.5%.  The portfolio taking on half the risk of the all stock portfolio outperformed it!  For investors over the same time frame that were chasing returns by jumping from equity positions to fixed income the returns could have been devastating depending on their timing.   The need for a plan becomes abundantly clear when looking at recent market trends and even more when looking at other historical performance results.

 What it essentially comes down to is stock picking is fun but real money is made through Asset Allocation over the long haul.

 This brings us back to bonds and if they need to have a place in your portfolio.  One of the most challenging aspects for investors to stay within their asset allocation model is accepting the fact that not every investment will be always be a winner or post the returns they desire.  The implementation and adherence to proper asset allocation almost guarantees that one of your asset classes will be getting hurt each year. The key is developing a plan and staying with it.  We will be the first to admit that when bonds are posting negative returns and the stock market is hitting new highs it is more than tempting to jump ship and chase returns but let history be your guide!

 As with any investment there are many different ways that you can gain exposure to an asset class.  Bonds are no different, the most common vehicles used by investors today are individual bonds, mutual funds and ETF’s (Exchange Traded Funds).  Each one has its positives and negatives and often investors will use a combination of them to round out the bond component of their portfolio.  One of the most important elements to consider is what are the fees associated with each?  The bond market in general is not nearly as efficient and transparent as the equity markets and investors can see substantially different prices in the same bond when comparing prices from multiple firms.  Mutual funds and ETF’s will both have a management fee associated with them – take the time to compare them and understand the difference with how these two popular options trade.  Mutual funds will trade once a day based on the closing price at the end of the trading day while an ETF will trade throughout the day but there can be a commission charged.

 Ultimately what it all comes down to is putting together your plan and realizing where bonds fit into that plan.  We would make the argument that every portfolio would benefit from some exposure to bonds.  Take the time to educate yourself and ask your investment professional so that you truly understand how bonds or fixed income products fit into your overall portfolio strategy.

 As always we welcome your comments and questions.  Please do not hesitate to contact us at your convenience.

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