Published on September 7, 2022 in the Rochester Business Journal

Through 7/31/22, Northern Trust reports negative year-to-date investment returns in nearly all areas of the bond market, with emerging market debt faring the worst (down 14.3%), followed by high yield debt (down 9.1%), investment-grade bonds (down 8.2%), municipal bonds (down 6.6%) and Treasury inflation-protected securities (TIPs – down 5%). The greatest contributing factor to these declines has been the Federal Reserve Bank’s campaign to raise interest rates – specifically, the Federal Funds rate, which is a short-term lending rate that many other lending rates are influenced by. Unfortunately for bond investors, when current interest rates go up, existing (high quality) bond prices come down, as investors demand a higher rate of return on their new investment dollars.

So far this year, the Federal Reserve Bank has lifted the Fed Funds Rate from a range of 0%-0.25% to a range of 2.25%-2.50%, in a series of four interest rate increases of 0.25%, 0.50%, 0.75%, and 0.75%, respectively. Its goal is to slow the economy down sufficiently to bring inflation under control, as year-over-year price increases amounted to 8.5% in July (as measured by the Consumer Price Index), after a trailing 12-month increase of in June. According to data published by the St. Louis Federal Reserve Bank, the Fed Funds rate is projected to rise to 3.4% by the end of 2022 and to 3.8% by the end of 2023. And so, if rates are to keep going up and existing bond prices are to keep coming down, it begs the question – why would an investor want to own any bonds at all right now?

In isolation, the easy answer to the question above is that an investor probably wouldn’t want to own any bonds right now. As part of a broadly diversified investment portfolio, however, bonds have strategic significance as a non-correlated asset that can positively influence investment returns over time. Being non-correlated means that bond prices typically (but don’t always) go up and down at different times than other asset classes (like stocks), which can help to dampen the year-to-year volatility (i.e. up and down price movement) of one’s portfolio. While it is generally true that less risk means less reward as bonds are introduced into a portfolio, it becomes incumbent on one’s investment advisor to match the risk of the portfolio to an investor’s specific goals, investment horizon, and explicit as well as implicit tolerance for risk. The end goal is to arrive at a portfolio that achieves all of one’s goals, while assuming the least amount of risk possible.

According to J.P. Morgan Asset Management and based on year-end calendar data from 1950 through 2021, the return of a 100% stock portfolio (as represented by the S&P 500 Schiller Composite Index) ranged from -39% to 47% for any given one-year period. For a 100% bond portfolio (derived from year-end data obtained from Strategas/Ibbotson from 1950 to 2010, and from the Bloomberg Aggregate Bond Index thereafter), annual returns ranged anywhere from -8% to 43%, and for a 50/50 mix of each, annual returns ranged from -15% to 33%. Over shorter periods of time, introducing bond exposure lessened both upside potential and downside risk, but the potential for negative annual returns was still present.

Things get more interesting when we look at introducing bond exposure to an investment portfolio over longer periods of time, such as rolling 5-year, 10-year, or even 20-year intervals over that same period. Here, the strategic significance of adding a non-correlated asset class (like bonds) to an investor’s portfolio are readily observed. For example, over any rolling 5-year period from 1950 to 2021, the 100% stock portfolio we referenced had an average annual return ranging from -3% to 28%, while the 100% bond portfolio had an average annual return ranging from -2% to 23%. The average annual return of a 50/50 portfolio comprised of each, however, had an average annual return of 1% to 21% - NEVER negative, which is very significant.

Similarly, over any given rolling 10-year period from 1950 to 2021, the average annual return of a 100% stock portfolio ranged from -1% to 19%, the average annual return of a 100% bond portfolio ranged from 1% to 16%, and the average annual return of a 50/50 portfolio comprised of each ranged from 2% to 16% - again, NEVER negative AND higher than the average annual return of what an investor would’ve realized in a “safer” 100% bond portfolio, simply by blending two or more non-correlated asset classes together.

Over any rolling 20-year period from 1950 to 2021, the results are the same – stocks had an average annual return of 6% to 17% (NEVER negative), bonds had an average annual return of 1% to 12% (NEVER negative), and a 50/50 portfolio comprised of each had an average annual return of 5% to 14% - NEVER negative AND higher than the average annual return of what an investor would’ve realized in a “safer” 100% bond portfolio, simply by blending two or more non-correlated asset classes together.

Investors typically buy bonds for the income they produce and the stability they can add to a broadly diversified investment portfolio. Based on the data mentioned above and the fact that bond returns can be non-correlated with other parts of the market, bonds are viewed as having the potential to improve “risk-adjusted” returns over longer periods of time, regardless of how they perform over shorter (i.e. year-to-year) periods of time. A financial plan should focus on an investor’s long-term goals and objectives. Similarly, the allocation of one’s investment portfolio should focus on the long-term strategic benefits of utilizing a non-correlated asset class like bonds, regardless of how such an asset class might perform in the near-term.

To see this column in the RBJ, click here.