Bond prices go up when rates go down, and rates have been doing just that since the Reagan Administration. Back in 1982, 10-year Treasuries were paying 15%, and after 30 years of steady decline, they dropped below 2% last year and trended down slightly for the first part of 2013. This remarkable three-decade drop in interest rates has been described as the ultimate bull market in bonds, perhaps the most rewarding period for bond investors in all of investment history.
But it's hard to see how bonds can continue much further on the same trajectory, unless you're predicting that people are going to be willing to pay for the privilege of owning Treasuries. Market prognosticators--whose profession is slightly less reputable than pickpockets or members of Congress--have been predicting for years that rates will go back up, perhaps dramatically, creating losses in the fixed-income part of your portfolio. We saw signs that the bull market in bonds might be ending this past month, when Treasury bonds maturing in 10 years or more declined 4% in value in three weeks, as the yield on 10-year Treasuries rose from 1.63% to just over 2.23% before dropping back to 2.12%.
U.S. equities are up, in aggregate, more than 15% this year. So the obvious question is: why should we have a portion of each investment portfolio in bonds?
The purpose of bonds in an investment portfolio is not to generate high returns--the past 30 years notwithstanding. Bonds protect against the worst kind of market risk--the times when stocks suddenly, unexpectedly plunge. The last time stocks took a nosedive, in 2008, U.S. equity markets seemed to be sailing toward another year of gains and bond prices were experiencing 30 year lows. Why own bonds in an environment like that? Yet by the end of the year, a mixed portfolio of bonds had achieved a 5.24% positive return, while stocks were losing 37%--meaning bonds outperformed stocks by more than 42 percentage points. In 2000, 2001 and 2002 when stocks dropped 9.11%, 11.89% and 22.10% respectively, bonds rallied to give investors returns of 11.63%, 8.43% and 10.26%. Over time, investors holding bonds enjoy a smoother market ride, and experience fewer losses during market downturns.
More importantly, having bonds (and cash) in your investment portfolio gives you options if and when stocks fall. If you need income, you can liquidate the bonds, rather than having to sell stocks at a loss. If the prices of stocks drop to the point where stocks become a screaming buy, you have some money set aside to buy at bargain prices and make up some of the losses.
If and when interest rates reverse themselves, and yields move up, you will experience losses in the bond portion of your portfolio. There are ways for professional investors and bond portfolio managers to reduce this risk--reducing the maturity or duration of the bonds from 10 years to 5 years or less, or holding more cash. But bonds are still your best protection against the unpredictability of stock market returns. We don't know what the markets are going to do next, and so the most prudent course is to keep protecting you against the possibility that another 2002 or 2008 is lurking somewhere around the corner.
Sources:
http://www.rickferri.com/blog/investments/a-reason-to-own-bonds http://bonds.about.com/od/bondinvestingstrategies/a/Stocks-And-Bonds-Year-By-Year-Total-Return-Performance.htm
http://www.bloomberg.com/news/2013-06-03/treasuries-erase-gains-as-fed-s-lockhart-raises-tapering-concern.html
Sincerely,
William T. Morrissey and Tammy Prouty
Sound Financial Planning Inc.
wtmorrissey@soundfinancialplanning.net
Primary Office
425 Commercial Street, Suite 203
Mount Vernon, WA 98273
Phone: (360) 336-6527
Secondary Office
650 Mullis St., Suite 101
Friday Harbor, WA 98250
(360) 378-3022
PLEASE READ THIS WARNING: All e-mail sent to or from this address will be received or otherwise recorded by the Sound Financial Planning, Inc. corporate e-mail system and is subject to archival, monitoring and/or review, by and/or disclosure to, someone other than the recipient. This message is intended only for the use of the person(s) ("intended recipient") to whom it is addressed. It may contain information that is privileged and confidential. If you are not the intended recipient, please contact the sender as soon as possible and delete the message without reading it or making a copy. Any dissemination, distribution, copying, or other use of this message or any of its content by any person other than the intended recipient is strictly prohibited. Sound Financial Planning, Inc. has taken precautions to screen this message for viruses, but we cannot guarantee that it is virus free nor are we responsible for any damage that may be caused by this message. Sound Financial Planning, Inc. only transacts business in states where it is properly registered or notice filed, or excluded or exempted from registration requirements. Follow-up and individualized responses that involve either the effecting or attempting to effect transactions in securities or the rendering of personalized investment advice for compensation, as the case may be, will not be made absent compliance with state investment adviser and investment adviser representative registration requirements, or an applicable exemption or exclusion. This information should not be construed as investment advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. WE WOULD LIKE TO CREDIT THIS ARTICLE'S CONTENT TO BOB VERES.
