With yields so low, does it still make sense to hold bonds?

December 21, 2010 Categories: Portfolio Corner
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I have heard from many advisors who are concerned we might be in a bond bubble. They want to know if it still makes sense to hold bonds in the current environment of extremely low yields. I thought that other advisors might be struggling with these same concerns, so I wanted to share my view. First, I don’t believe that we are in a bond bubble. Second, I believe there’s a strategic case for owning bonds, even if rates rise. It may seem counter-intuitive at first, but take a look at my reasons below and feel free to let me know what you think in the comments section of the blog.

Why I don’t think it’s a bubble

  1. Bubbles have historically been characterized by large losses, and big capital losses over long periods of time are not expected from bonds given the obligation bond issuers have to repay the principal amount borrowed.
  2. Additionally, bond returns are derived mainly from coupon income and not price appreciation or loss (as shown in the graph below). The coupon payment provides a cushion of stability that also helps protect against loss.
Three year rolling averages of bond returns

Source: Barclays Capital. Returns shown are from monthly Barclays US Aggregate Bond Index returns from January 1976 to November 2010.

As a result, I don’t believe bonds are in a bubble. But even so, that doesn’t mean interest rates won’t rise, so let’s look at why I don’t think that’s a reason to stop holding bonds.

What happens to bonds if interest rates rise?

Your clients need to understand the impact a change in interest rates will have on the performance of their bond portfolio. This can be estimated using a mathematical formula that uses a simple measure of interest rate sensitivity called duration:

Change in Interest Rate x Duration (in years) = % Impact on the portfolio

As you can see, the longer the duration , the more sensitive the portfolio is to changes in interest rates. For example, a portfolio with a duration of 4 years will be twice as sensitive to a rise in interest rates as a portfolio with a duration of 2 years.

As an example, if we assume interest rates increase half a percent (or 50 basis points), and your client’s portfolio has a duration of four years, the price of their holdings would decrease 2%:

0.5% x 4 yrs = 2%

Remember, bond prices move in the opposite direction of interest rates changes, so an increase in rates causes a decrease in bond prices and vice versa.

But wait, there’s more

In the above example, you saw that a rise in interest rates will negatively impact bond prices. However, that is only part of the story. The coupon payment of the bond continues, and that positive income will provide a bit of a cushion against the price hit the bonds take. The total return of a bond is equal to the change in the bond’s price plus the income it pays. So, when we look at both the price of the bond and the income generated by the coupon payment the effect of an interest rate increase may not be that bad. In fact, if the income the bond pays is greater than the price loss, the total return will be positive.

The strategic case for bonds is well known, but just for review, bonds provide one of the best hedges against equity risk, which still remains the predominant risk in the average investor’s portfolio. This holds true in all kinds of interest rates environments over reasonable time periods. So low interest rates are no reason to dump your clients’ bonds.

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