by Guy Baker
Conventional wisdom says that when stocks fall, bonds (particularly Treasurys) will pick up the slack. During April’s tariff announcements, however, stocks tumbled as expected, but bond yields rose, meaning their prices fell and didn’t come to the rescue. For many investors (and some advisors), 2022 felt like a déjà vu when both stocks and bonds tanked by double digits amid high inflation and a series of Fed interest-rate hikes.
Some clients may be fearful that bonds are no longer a reliable hedge against stock market volatility. I wouldn’t go that far, but now might be a good time to review the myths and misconceptions about bonds in your portfolio.
Seven Common Misperceptions About Bonds
- Bonds are always safe. While it’s true that bonds are generally less volatile than stocks, they are not risk-free. When an investor purchases a bond, they lock in a coupon rate and a maturity value. But a lot can happen between the purchase date and the sell date. Bonds held to maturity expose investors to the risk of inflation and a loss of purchasing power. But that’s not all. The coupon rate prices in credit risk in case the issuer runs into financial difficulties and defaults. The higher the risk, the higher the coupon rate required to attract money. Investors must be aware of the risks associated with the bond terms and the credit risk.
For instance, a 10-year bond earning 5% with an AA credit rating and a two-year bond earning 5% with an AA credit rating face entirely different risks if interest rates increase. The liquidation value will be impacted significantly more for the 10-year bond than for the 2-year bond. This impact is called duration risk. The longer the duration, the more a bond’s price will fluctuate in response to changes in interest rates. Generally, bonds will state their duration risk. If the duration risk is 4%, it means that for every 1% rise or fall in the interest rates, the bond value will adjust up or down by 4%. So, a bond with a face value of $100,000 would be expected to decline to $96,000 if the interest rate increased by 1%. However, if the investor holds the bond to maturity, they are contractually guaranteed they will receive the full face value (assuming no default). - Rising interest rates always hurt bonds. While it’s true that higher rates can negatively affect the price of existing bonds, it also means there are opportunities to invest in higher yields, thus benefiting long-term investors. Additionally, if the general economic climate suggests rates will come down, buying a 30-year bond with a 20% discount off its maturity value represents a substantial appreciation opportunity in the bond value, and the investor still receives the coupon rate annually.
- Bonds are only for retirees. Bonds can play a crucial role in portfolio diversification for investors of all ages, as fixed income helps balance out risk and provides a steady income. The investor’s risk capacity—the amount of tolerable risk given their time horizon—is often very different from their risk tolerance—their comfort level with short-term volatility, such as what we are seeing today. Even for young investors and others with a high risk tolerance and/or a long time horizon, a modest allocation to bonds can help insulate a portfolio against stock volatility without sacrificing too much upside.
- Government debt causes bond yields to skyrocket. Everyone is concerned about the federal government’s nearly $2 trillion annual deficit. Sure, large deficits can influence interest rates, but several factors determine bond yields, including investor demand and the Federal Reserve’s interest rate policy. Some investors may fear that the U.S. government will default on its obligations, thus making all outstanding Treasuries worthless. While anything can happen, a government default would have a catastrophic global impact and seems unlikely. Generally, our firm maintains a short-term approach in its bond portfolios to minimize duration risk. But in times when interest rates are likely to drop a full 100 to 200 basis points, investing in 30-year Treasuries can be an exceptionally good option.
- Corporate bonds are too risky for retirees. Unlike investors in Treasuries, investors in corporate bonds must evaluate both credit risk and duration risk. Highly rated corporate bonds can be a valuable part of a diversified bond portfolio since they typically offer higher yields than U.S. Treasuries. Plus, the income stream is predictable, and the default rate, while higher than Treasuries, is relatively low compared to junk bonds and other lower-rated corporate debt.
- Individual bonds only make sense for very large investors and institutions. Conventional wisdom says an investor needs significant capital to achieve diversification with bonds and must constantly monitor which of their bonds are maturing. However, holding individual bonds (as opposed to bond funds) can be advantageous regardless of size. Here are three reasons why:
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- Predictable returns since the investors receive fixed interest payments and since the principal is paid back in full at maturity, assuming there is no default.
- Control. You can choose specific bonds that allow customization based on credit, maturity, and industry.
- Tax benefits. Taxable bonds generate interest income that is taxed at ordinary income rates (federal and state), especially if the bonds are sold for a profit before maturity. But if the investor holds a bond until maturity, they avoid capital gains tax since their return is considered a return of basis, not a gain. Investors can also eliminate income taxation on bonds by investing solely in Treasuries (which are not taxed at the state or local level) and municipal bonds (which are tax-free at the federal and sometimes at the local level).
- Bond funds offer no control to individual investors. Unlike with individual bonds, investors cannot hold the bonds inside a bond fund to maturity or sell them prematurely if they wish. Further, bond fund returns are unpredictable. The income will vary depending on the mix of holdings based on coupon rates at the time of purchase. The greater the interest rate volatility, the wider the range of monthly distributions will be. Just know that funds buy and sell their holdings based on interest rate movements and capital inflows and outflows. Most investment managers hold bonds to maturity inside their fund. However, because of the fund’s broad diversification, the bond maturities will vary depending on the date of purchase. However, bond funds offer several advantages:
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- Diversification. Which is very hard for smaller individual investors to achieve. Bond funds hold a large portfolio of investments, which mitigates the impact of defaults.
- Liquidity. While an investor can sell individual bonds, a process is involved, and it may take time to find a buyer. With a bond fund, investors can typically liquidate their holdings within one day.
- Lower transaction costs. Bid-ask spreads are typically larger for small transactions, which can translate to lower returns. Institutional asset managers, which buy and sell large quantities of bonds, can command higher prices for sales and lower prices for buys, which can add up to a transaction cost advantage over individual bond portfolios.
- Professional management. Fund managers can find opportunities to buy bonds at a discount to take advantage of interest rate flow, which is very hard for individual investors to do.
Conclusion
In the final analysis, bonds are an important financial instrument for building a predictable income strategy for investors. Still, it is essential to understand that what is seen is not always what investors will get.