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Bonds: The Necessary Evil

Conventional wisdom tells us to get out of bonds. But is that the right move to make today?


EXECUTIVE SUMMARY:

  • The Federal Reserve has clearly indicated it plans to raise rates in 2022.

  • Rising rates would normally push investors to move out of longer-term bonds.

  • While bonds will depreciate in value when interest rates rise, they eventually mature at par and can recover their losses.

  • When stocks are in a free-fall, holding bonds has historically served as a shock absorber for the portfolio.

  • In today’s market, it may make sense to hold a portion of your portfolio in bonds. 

With inflation rising around the globe, fixed-income investors have seen rising interest

rates cause a fair amount of pain in their traditional bond allocations.


January 2022 was one of the worst-performing months for the Bloomberg US Aggregate

Bond Index (a broad index of US bonds)(1) spanning the past 20 years. Most of the blame

lies with the increase in interest rates. The 10-year US Treasury note(2) rose from 1.49%

at the start of the year to 2.00% in early February. This, ironically, was a similar repeat

to what we saw in early 2021 when interest rates rose quickly, but then settled back

down later in the year.

With inflation rates at the highest levels in decades, it would be reasonable to expect higher future long-term interest rates. Adding in the outrageous amount of stimulus money the federal government has flowed into the economy over the past two years, it’s difficult to see an environment where inflation settles down.


In most scenarios, these data points might push us away from holding bonds and other interest-rate sensitive assets towards assets that benefit from inflation. While this makes sense in theory, there are other reasons to consider holding bonds today.


They are there when you need them.


The traditional role for bonds has been to produce an income and reduce the volatility of the investment portfolio. While these two benefits are severely muted in today’s market due to extremely low interest rates, high-quality bonds are one asset class with the potential to hold up when everything else hits the fan.


In looking back over the past 20 years, there have been 14 periods when equities (as

represented by the S&P 500 Index)(3) lost more than 3% (FIGURE I). In all but one of

those quarters, the Barclay’s Aggregate (a broad index of high-quality US bonds)

protected investors from additional losses. In the majority of these scenarios, holding a

portion of the portfolio in high-quality bonds would have helped to reduce the pain.

Holding a portion of your portfolio in high-quality bonds may help reduce the pain of equity market losses.


The Bottom Line

The Fed has clearly indicated their intention to begin raising interest rates(4). If long-term

interest rates follow the Fed’s lead and begin to rise, bonds are likely to continue to depreciate in value throughout 2022.


We’ve written extensively in the past about why we don’t like bonds at the current

interest rates. But every time we’ve written about this, we’ve stated that they are a

necessary evil in the portfolio. While their income is limited and their upside is muted,

high-quality bonds are one of the few places to hide when the equity markets are getting

crushed.


There is no free lunch in the bond market today! But the primary role of bonds in a

portfolio remains the same: to provide some level of protection in the event of an equity

selloff. If you need some help with your financial affairs, reach out to Monotelo Advisors

for a no-obligation 15-minute discovery meeting.





1 The Bloomberg US Aggregate Bond Index is composed of securities from the Bloomberg Government/Credit Bond Index, Mortgage-Backed Securities Index, Asset-Backed Securities Index, and Commercial Mortgage-Backed Securities Index.

2 The 10-year Treasury note is a debt obligation issued by the United States government with a maturity of 10 years upon initial issuance. A 10-year Treasury note pays interest at a fixed rate once every six months and pays the face value to the holder at maturity.

3 S&P 500 Index is a market capitalization-weighted price index composed of 500 widely held common stocks.

4 The federal funds rate is the target interest rate set by the Federal Open Market Committee (FOMC). This target is the rate at which commercial banks borrow and lend their excess reserves to each other overnight.



This article is a general communication being provided for informational and educational purposes only and is not meant to be taken as tax advice, investment advice or a recommendation for any specific investment product or strategy. The information contained herein does not take your financial situation, investment objective or risk tolerance into consideration. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. Any examples are hypothetical and for illustration purposes only. All investments involve risk and can lose value, the market value and income from investments may fluctuate in amounts greater than the market. All information discussed herein is current only as of the date of publication and is subject to change at any time without notice. Forecasts may not be realized due to a multitude of factors, including but not limited to, changes in economic conditions, corporate profitability, geopolitical conditions, inflation or US tax policy. This material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed.




LEGAL, INVESTMENT AND TAX NOTICE. This information is not intended to be and should not be treated as legal, investment, accounting or tax advice.




PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.



Copyright 2021. Monotelo Advisors Inc. All Rights Reserved


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