Why investors shouldn’t panic over falling bond prices
Investors holding government bonds in their portfolios may find it alarming that so-called safe assets did little to stem the bleeding during the latest bout of volatility in the stock market, but they shouldn’t overreact, according to financial advisors.
The iShares Core U.S. Aggregate Bond ETF AGG, +0.01% is still down 2.3% year to date. Meanwhile, the S&P 500 SPX, +0.19% which dropped 10% from its peak on Jan 26 and through last week, has taken back a chunk of its lost ground. After Monday’s bounce, the index was 7.6% off its all-time closing high from Jan. 26 and was down about 1% since the start of the year
Read: Stocks and bonds did something last week that hasn’t happened since 2004
The value of bond funds fell along with prices of U.S. government debt. In fact, the 10-year Treasury yield TMUBMUSD10Y, -0.66% jumped Monday to a high just shy of 2.9%, the highest level since 2014 since the start of the year.
Bond prices move inversely to bond yields.
But bond fund values should not be confused with total returns, which benefit from interest payments that are continuously reinvested or paid out as income. In theory, it should be impossible to lose money by holding safe investment-grade bonds until maturity.
Meanwhile, history shows bond funds tend to recover from downturns, providing positive returns over the long term, according to analysts at AllianceBernstein.
“Since 1993, the Bloomberg Barclays US Aggregate Index, dominated by government and investment-grade corporate bonds, fell 1.2% on average during months when yields increased by at least 0.3%. But it rose 2.6% over the next six months,” AllianceBernstein wrote.
“Over the short term it may seem like there is no place to hide when your stocks are falling and your bonds are hit. But focusing on the short term when it comes to bonds is counterproductive,” said Dana D’Auria, director of research at Symmetry Partners, a Glastonbury, Conn.-based asset manager.
“In a scenario like now, people would think that going to cash is a good option. The problem with that is you don’t know when to reinvest that cash. Sitting in cash means that there is always an opportunity cost,” D’Auria said.
Since 1923, the 10-year Treasury note has never seen a nominal annual loss of more than 12%, according to Ben Carlson of Ritholtz Wealth Management. That’s smaller than typical correction in stocks of around 15%.
And matching the holding period to the average duration of a bond fund is a good way to assure positive returns.
Duration is the time it takes for investors to recover their initial investment from the cash flows, or interest payments, of a bond. Because of interest payments, the duration of a bond is shorter than its maturity and the higher the yield, the shorter the duration. The longer the duration of the bond, the more sensitive its price is to changes in interest rates.
The AllianceBernstein analysts calculated the impact of a larger selloff on bond fund returns and found that “investors who take a long view can rest easy.”
“A year after the 1% spike [in yields], the seven-year U.S. Treasury TMUBMUSD07Y, -0.81% whose duration is similar to the U.S. Aggregate’s, would be down almost 2%. But over time, higher yields lead to higher returns. Our analysis suggested that investors who sat tight for three years and reinvested their coupons could have earned a cumulative return of 6%. Six years later, the return in our analysis was nearly 17%,” AllianceBerstein wrote.
So, over the long term bonds still play an important role in a portfolio: they act as cash proxy when stocks are falling, as well as a hedge because overall they do tend to reduce the roller-coaster effect of stocks.
During bear markets, when stocks fall more than 20% and take months to recover, Treasurys tend to cushion the blow. In the chart below, Carlson provides historical returns during the bear markets since World War II and corresponding returns from 5-year Treasurys TMUBMUSD05Y, -0.20%
“Bonds are your safety net. They are there to smooth out the ride and not for getting rich,” said Carolyn McClanahan, financial planner at Life Planning Partners Inc. “Investors should rebalance regularly and based on their asset allocation strategy that they put in place.”
“If you are still scared, then you are most likely invested inappropriately for your goals,” she said.
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