Much like a runner needs a functional core to increase their distance, or a weightlifter requires a strong core if they want to increase the load on all their other lifts, investment portfolios need a stable, strong core in order to support growth over time.
And, just as most runners will tell you it’s much easier for them to focus on getting in the miles than committing to a grueling core workout, many investors tend to put their interest in the exciting parts of their asset allocations rather than the unloved and somewhat forgotten core bonds components.
Core bonds are investment-grade U.S. fixed-income issues including government, corporate, and securitized (i.e. – mortgage-backed) bonds. These types of bonds are of high credit quality and come with lower relative risk. As a result, they offer corresponding lower yields.
With interest rates at such low levels, these high-quality investments generate less income than some of their riskier counterparts. That’s reduced their appeal to some investors. Additionally, some experts suggest that investors look to other, riskier options for their bond portfolio for better returns, due to the lower yields on core bonds.
In our view, such a strategy could cause more harm than good for investors pursuing their long-term financial goals. The biggest challenge investors face to performing over time is trying to outperform all the time. Let me make the case for keeping a strong core as an integral part of your overall portfolio.
Core Bonds Provide More Benefits Than Just Income
Core bonds play a critical role within a balanced investment portfolio by providing income, principal protection, and diversification. While low interest rates have lessened the income benefit, the other key benefits of core bonds are still important to your overall financial well-being.
When stocks zig, core bonds often zag. We saw this pattern play out in early 2020, when the S&P lost a staggering 33% of its total value. During that freefall in stocks, intermediate core bonds lost only 3.2%. Core bonds outperformed stocks by 30%, and helped reduce the overall impact of the market drop in investor’s portfolios.
In the table to the right, you can see how other bond sectors and strategies that are trendy right now fared during the market’s freefall.
Portfolio A – a simplified portfolio of 60% S&P 500 and 40% intermediate core bonds – incurred a loss of 21.4% over the time period in the table. Now compare that to Portfolio B, made up of 60% S&P 500 and the other 40% allocation equally divided among the bond and bond proxies. It suffered a 26% decline in the same timeframe.
The difference in portfolio results may not seem that significant until you translate the percentages into real dollars. An investment of $500,000 in Portfolio A would have lost $107,000, while an investment in Portfolio B would have declined $130,000. As a reminder, this precipitous decline occurred in only a month’s time.
The best portfolio for any investor is one that allows them to remain invested through good times and bad times. Portfolio A would have given investors a much better chance to remain invested in the depths of the market decline, considering its value was $23,000 greater than Portfolio B.
Same Risk, Less Reward
There’s no such thing as a free lunch. Investors considering leaving their core bond portfolios behind in favor of substitutes that promise higher returns should be mindful that an increase in expected future returns also adds additional risk. It also means diminishing the diversification benefits of your bond portfolio – as the table above reminds us.
And moving away from core bonds in favor of substitutes may not even provide the increased return you’re seeking in the first place.
Here is a graph of credit spreads for high-yield (or below investment grade) bonds over the past 10 years.
High yield bonds pay a premium income compared to core bonds because they are issued by companies with lower quality balance sheets and have greater risk of not repaying their debt. That premium income is measured by credit spread, which is the amount of income an investor earns above a “risk-free” bond issued by the U.S. government with a similar maturity.
Over the past 10 years, high-yield bonds have averaged a premium of 4.91% above risk-free treasury bonds. On March 23rd last year, in the depths of the market decline, the premium was an attractive 10.9%. Today, that premium above a risk-free bond is roughly 3.50%, well below the 10-year average.1
On a historical basis, investors are being compensated very little for the additional risk of owning riskier bonds and bond proxies. It’s bad enough that the return on these riskier investments is near 10-year lows. The risks associated with such investments are the same, adding insult to injury.
Inflation is Coming! …Or Is It?
One of the common arguments for shifting a portfolio away from core bonds centers around the “probability” that interest rates will move higher in the near term due to inflation. Such an outcome would be more harmful to high-quality bonds that have lower income streams than higher-income alternatives.
The risk for higher inflation centers around the combination of pent-up consumer demand that will be unleashed once enough Americans receive coronavirus vaccines, and the considerable amount of fiscal and monetary stimulus that has been injected into the economy over the past year. Since March 2020, the Fed has cut rates to 0% while expanding its balance sheet by $3 trillion, while the government’s fiscal support has exceeded $4 trillion to date.
While these inflation risks are real, investors would be wise to avoid considering the outcome already decided.
During the Great Recession that ran from 2007 to 2009, U.S. policy measures looked similar to 2020’s interventions: the Fed slashed interest rates to 0% and the government provided trillions in stimulus to support the U.S. economy. At the time, many experts predicted this would lead to significant inflation in the future. But in reality, inflation has remained stubbornly below the Fed’s 2% target over the past decade.
Two factors that helped keep inflation at bay then are still in play now: technological advances and slowing population growth. Also dubbed the Amazon effect, advances in technology allow companies to improve efficiency and cut costs which puts downward pressure on consumer prices. A slowing birth rate in the U.S. over the past several decades combined with a more restrictive immigration policy has left fewer consumers to drive the U.S. economy, which reduces upward pressure on prices.
Still, we can see a risk for moderately higher inflation in the future. The best inflation hedge in a portfolio is an allocation to equities. If consumers do in fact go on spending sprees after being vaccinated to drive economic growth, that should directly benefit corporate earnings, which should give further support to stock prices.
Meanwhile, investments such as high yield bonds, bank loans, and preferred stocks have historically performed better in a rising rate environment than core bonds. But, investors should remember that the enhanced performance comes in large part due to these investments increased credit risk. Again, there’s no free lunch.
Investors shouldn’t view such investments as a substitute for high-quality core bonds in their portfolio, but rather as a complement.
Preserving Your Core Strength
When investors think about constructing the optimal portfolio, they should always consider their return objectives, comfort with risk, and time horizon. When considering using substitutes for core bonds in your portfolio, it’s comfort with risk that you should be most mindful of. As we showed above, most other options will carry greater risk and will provide less protection when stocks decline.
Core bonds often perform well when stocks fall; that’s what makes them an essential part of your portfolio. The goal should not be to create the portfolio with the absolute highest returns possible, because that introduces far too much risk. Instead, you should choose the portfolio that gives you the strength and stability to remain invested over the long-term, through up markets and down markets.
By having a dedicated portion of your portfolio invested in core bonds, investors will be better prepared to weather unexpected storms like 2020 when they arise.
Source: 1 https://fred.stlouisfed.org/
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