Most investors view bonds as safe securities providing a fixed income until maturity. Especially after experiencing dramatic losses in the stock market, investors may look to bonds to provide a safe haven from the volatility of stocks. But the truth is a portfolio of bonds can be nearly as risky as stocks, and is certainly more risky than a blended portfolio of stocks and bonds.
Why Bonds Can Be Risky
One rule of investing is that as interest rates rise, the price of a bond falls. This is known as interest rate risk. To see this, imagine that you purchase a bond paying 6% and interest rates go up to 7%. Your bond is now less valuable in the marketplace. You may be asking yourself, “But, what if I hold my bond until maturity?” It is true that you will recoup your principal at maturity, but you will still have suffered years of portfolio value fluctuation and be locked into an interest rate below current market rates.
Bonds Are Especially Risky When Interest Rates Are Low
When interest rates are at their lowest, the potential for volatility in bonds is at its highest. This was demonstrated dramatically last summer. Interest rates had hit forty-year lows. Then investors became concerned that the Federal Reserve Bank would raise interest rates in response to strong economic growth. As a result, intermediate-term bonds lost 10% of their value in just two months. Fears faded last fall as economic growth slowed slightly and bonds recouped half of their losses. But, bonds were hit again in the second quarter of this year as inflation picked up and economic growth continued. Yields on intermediate-term bonds rose by 1.125%, and bonds lost another 9% of their value.
Bonds Still Have a Place in Diversified Portfolios
We include bonds as part of our conservative models for a reason. Over long periods of time, bonds do reduce the volatility or risk in a portfolio without substantially reducing the expected return. This is because bonds historically return about 5% to 6%, and have a low correlation to equities, meaning the prices of stocks and bonds often move in opposite directions. As interest rates rise due to strong economic growth, equities usually outperform bonds. But, when economic growth declines and stocks suffer, bonds are usually stellar performers. An allocation to bonds over the last three years would certainly have reduced overall portfolio risk. The Lehman Brothers Aggregate Bond Index returned 7.44% over the last three years while the S&P 500 Index returned -3.34%.
We expect that interest rates will continue to rise over the next few years. In this environment, bonds alone could be just as volatile as stocks. However, when included in moderate amounts in diversified portfolios, bonds will serve their intended purpose of reducing the overall volatility of the portfolio and helping to meet the required income needs of our clients.