Assessing Bonds in Your Portfolio
Quick Take
Bond performance has been disappointing due to higher inflation and Fed rate hikes over the last three years.
Poor bond performance has led some to question the merits of bond funds. We see benefits of both individual bonds and appropriate low-cost funds, but personal circumstances dictate the best approach.
The relationship between stocks and bonds can be fickle, but over time economic drivers of returns will support a balanced approach.
The stock market has reached new highs, and the artificial intelligence revolution has spurred excitement. While all this is encouraging, most investors balance their stocks with bonds, smoothing the swings and occasionally gut-wrenching gyrations of the stock market. That shock absorber has been disappointing in the last several years. Does this mean bonds are dead and should be shunned in a balanced portfolio? Not quite.
In 2022, the Federal Reserve shocked the bond market by raising short-term interest rates higher and faster than most expected. This resulted in higher yields and a drop in bond prices, making the bond market's performance one of the worst on record.
It has been rough for bonds since the yields hit a nadir in 2021. If you began investing in bonds at peak prices (low yields) in 2021, you would likely still be underwater. And while bonds posted good returns in 2023, the bond market has far from recovered.
Poor bond performance has been both disappointing and unusual. Typically, a portfolio's volatility comes from riskier stocks. Over the last three years, global stocks have gained a total cumulative return of 16%, while bonds posted a loss of 9%. A traditional mix of 60% global stocks and 40% bonds has returned an annual average of 2.3% over the last three years. More conservative mixes with more bonds had lower average returns.
Stocks have recovered, and the bond market is still well below the high-water mark. Stocks have proven to be a better investment through this inflationary shock. Corporations have navigated higher interest rates and passed higher prices to their customers.
Bonds vs Bond Funds – Is One Better?
We have received several questions on bond funds. For many, what happens to a bond's price is less concerning as long as you get your money back at maturity. That can be comforting, but also something of an illusion, as higher inflation has caused the drop in bond prices. That same “get my money back” comfort is absent with bond funds, where maturities and reinvestment happen within the fund.
But bond funds are portfolios of bonds. Take the bonds out of the fund, and the performance would be the same (excluding fund fees, which are low for our preferred index funds).
Wall Street Journal columnist Jason Zweig opposes using bond funds, arguing in favor of owning individual bonds to meet future cash flows.
It's wrong to lump all bond funds into a single category. What matters is the type of bond fund and its underlying risk characteristics (maturity or duration risk, credit, etc.). The objective and role in a portfolio are also critically important. A misalignment between an investment and objectives can lead to problematic outcomes like any other investment.
Bonds, whether acquired through a fund or directly, have two primary uses. The first is to create an income stream to meet future cash needs. The second is to dampen a portfolio from the occasionally stomach-churning swings of a stock portfolio. Individual bonds or bond funds can accomplish either or both.
Bond funds make bond ownership more accessible, and low-cost investment options provide instant diversification, which is essential for a portfolio of credit-sensitive bonds. Individual bonds can offset future cash flows. One approach isn't necessarily better; sometimes, a blend of funds and bonds is best. In today's market environment, some investment opportunities are best expressed via direct bond holdings, while bond funds are more appropriate in other situations. Individual circumstances and needs determine the best approach.
What It All Means
Diversification can be a funny thing. The main idea is that owning assets that zig when others zag will smooth the ride, leading to better outcomes. Diversification also comes in many flavors. It doesn't work every day, week or month. But over time, the economic drivers of returns support the diversification benefits of a moderate mix of stocks and bonds.
Diversification means preparing your portfolio for a range of outcomes that you can live with. While no one likes a bout of inflation, deflation or an economic contraction can also wreak havoc on a portfolio. In those cases, bonds will likely serve their portfolio-dampening role. Diversification also means there will be times when there is a part of the portfolio you will scorn and another part you will celebrate.
Contact us at 865-584-1850 or info@proffittgoodson.com
DISCLOSURES: The information provided in this letter is for general informational purposes only and should not be considered an individualized recommendation of any particular security, strategy, or investment product, and should not be construed as investment, legal, or tax advice. Proffitt & Goodson, Inc. makes no warranties with regard to the information or results obtained by third parties and its use and disclaims any liability arising out of, or reliance on the information. The information is subject to change and, although based on information that Proffitt & Goodson, Inc. considers reliable, it is not guaranteed as to accuracy or completeness. Source information is obtained from independent financial data suppliers (Interactive Data Corporation, Morningstar, etc.). The Market Categories illustrated in this Financial Market Summary are indexes of specific equity, fixed income, or other categories. An index reflects the underlying securities in a particular selection of securities picked due to a particular type of investment. These indexes account for the reinvestment of dividends and other income but do not account for any transaction, custody, tax, or management fees encountered in real life. To that extent, these index numbers are artificial and cannot be duplicated in real life due to the necessity of paying those transaction, custody, tax, and management fees. Industry and specific sector returns (technology, utilities, etc.) do not account for the reinvestment of dividends or other income. Future events will cause these historical rates of return to be different in the future with the potential for loss as well as profit. Specific indexes may change their definition of particular security types included over time. These indexes reflect investments for a limited period of time and do not reflect performance in different economic or market cycles and are not intended to reflect the actual outcomes of any client of Proffitt & Goodson, Inc. Past performance does not guarantee future results.
