When the COVID pandemic began just over one year ago, the Federal Reserve lowered rates from 1.75% to near 0%, causing yields on fixed income instruments across the spectrum to drop to historic lows. This helped cushion the blow from the pandemic, but it also created a conundrum for investors to consider – should I buy bonds at such low levels? The answer to this question is nuanced and one that requires an understanding of your overall goals and time horizon. Ultimately, the reason for holding bonds (or fixed income) in your portfolio goes beyond interest rates, and, for most investors, some allocation to fixed income investments likely makes sense.
Some of the arguments against owning fixed income are:
1. Historically Low Yields: Yields are at historically low rates, and, when factoring for inflation, the yields on government bonds are negative. Why would someone buy bonds with negative returns?
2. Potential Price Decrease: If interest rates go up, you may lose money on your bonds (bond prices fall when rates go up), so why not stay in cash until rates go up?
3. Lower Comparable Returns: Compared to other investments, such as stocks, real estate, commodities, bitcoin, art, etc., the return on fixed income is meager at best. Why not buy these other types of investments instead?
4. Too Small of a Portfolio: You must have a much larger portfolio to “just live off the interest” on your bonds.
There are many reasons to consider owning fixed income:
1. Relative Safety: Investing in bonds lets you sleep at night. The “fixed” in fixed income means you have some certainty of interest earned and principal received, especially in a laddered bond approach. Therefore, you can avoid permanent loss of capital in your portfolio by allocating to fixed income investments. This psychological factor (the peace of mind that comes with investing in fixed income) is extremely important, especially if you depend upon their portfolio assets to meet your financial goals.
2. No “One Size Fits All” Approach: Buying bonds is not just about buying government bonds, which have the greatest safety but the lowest yield. It is also about diversifying into other areas. Corporate bonds, for instance, have yields greater than those of treasury bonds, and if your tax rates are high enough, municipal bonds offer compelling after-tax returns. These higher returns more than compensate for the elevated risk relative to government bonds.
3. Potential for Higher Reinvestment Yields: As a fixed income investor, you ultimately want rates to be higher to earn a higher yield on your investments. The lower yield you accept initially does impact your returns, but, depending on your strategy (assuming you are not investing only in long-term treasury bonds), your returns should increase as rates rise. At higher rates you can reinvest income and rebalance from other parts of your portfolio into higher-yielding bonds.
4. Increased Diversification: When trying to preserve wealth, portfolio construction is about diversification, owning assets that move in different directions at similar times (i.e., low or negative correlation). Bonds tend to change in value much slower than stocks; a bad year in bonds is like a bad day in stocks. At the end of March 2020, corporate bonds were down 2.5% for the year, while the S&P 500 was down 20% for the year. You can rebalance away from fixed income to equity investments when a correction occurs.
Ultimately, each investor should have an allocation that is right for them, one that aligns with their goals and values for their financial life. In most cases, the use of bonds or fixed income in a portfolio is necessary to meet these goals and allow for proper diversification. You should have a plan that considers a variety of market situations and is suited to meet your future needs.
The information presented in this article is for educational purposes only and is not meant to provide individual advice to the reader. There is no guarantee the information provided above relates to your personal situation. All financial situations are unique and should be advised as such.