Don’t Overlook Bonds
In the financial markets, stocks usually get all the attention. This year, however, stocks have had to share the spotlight with cash investments – CDs, Treasury Bills, and the like. According to Bank of America, investors have jumped at the opportunity to park money in cash at these higher interest rates, with money funds attracting $925 billion in fund flows. However, amid all this excitement around short-term yields, don’t overlook bonds, which are also enticing.
Stocks retreated modestly in August. Global stocks declined 2.8%. The S&P 500 fell 1.6%, ending its run of five straight monthly gains. Despite the pullback, stocks are still up solidly this year. Global stocks are up 14.8%, led by shares of the largest US companies.
This optimism has been due to a reset of expectations around a potential recession - a recession that hasn’t happened yet. Declining inflation and healthy job gains have continued despite higher short-term interest rates. Yields have continued to rise on expectations that the Fed will hold interest rates higher for longer.
While interest rates have continued to rise this year, this hasn’t translated into losses for the bond market. The math has changed with interest rates now higher. Bond prices go down when yields go up. However, this ignores the income component of a bond’s total return. This year, higher yields have cushioned the impact of higher interest rates. While the yield on the 10-year Treasury has risen 0.38% this year to 4.3%, the broad bond market, measured by the Bloomberg Aggregate Index, has returned 1.4% through August.
Over short periods, the price return can overwhelm the income component for a bond or a portfolio of bonds. Last year’s dismal bond performance was a reminder of just how bad that can be. But stretch out the time period, and the opposite is true. The income component takes the front seat. The yield of a bond or a bond portfolio is a reasonable approximation of the return over the average life of the bond or portfolio of bonds. The chart below illustrates how the yield on the Bloomberg Intermediate Aggregate index approximates the return over the subsequent five years.
Is Cash King?
With the yield on the 10-year reaching 4.3% and investment-grade corporate bonds yielding 5.6%, it’s been nearly 15 years since long-term yields have been this high. Things are looking up for bonds.
With enough time, it’s rare for Treasury Bills or other so-called cash equivalents to outperform long-term bonds. Since 1930, there have only been four five-year periods where Treasury bills beat bonds. Of those four, only between 1975 and 1980 did bills beat bonds by any significance.
Between 1980 and 1985, Treasury Bills returned a whopping 10.3% annual average, only to be outdone by a 15.8% return on bonds. Bonds beat bills despite Treasury Bills out-yielding intermediate bonds 13% to 10%. As discussed before, buying and reinvesting short-term Treasury Bills and CDs has historically been a poor substitute for a well-diversified bond portfolio.
What It All Means
For many balanced accounts, the gains in the stock market have left accounts above their long-term targets for stocks, creating an opportunity to rebalance part of the portfolio back into bonds at higher yields and realigning with long-term risk targets. We have been evaluating this for our client portfolios.
Even within stocks, rebalancing is good for portfolio health. Gains in several of the largest companies have led to a dispersion between valuations of the large US companies and smaller ones. The S&P 500 trades at roughly 21 times earnings. However, most of the premium is top-end loaded in the largest ten stocks. The median price-to-earnings ratio for the bottom 490 stocks is only 17 times earnings, illustrating just how the largest technology companies have benefited from the enthusiasm in the stock market. We believe it’s prudent to realign portfolios and exposures within the stock portfolio to keep consistency over time.
Please let us know if you would like to discuss your situation in more detail.
Contact us at 865-584-1850 or info@proffittgoodson.com
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