Our Bond with Bonds (Even in a Low-Interest-Rate World)
MODERNIST’S ASSET CLASS INVESTING PORTFOLIOS ARE STRATEGICALLY INVESTED WITH A FOCUS ON LONG-TERM PERFORMANCE OBJECTIVES. PORTFOLIO ALLOCATIONS AND INVESTMENTS ARE NOT ADJUSTED IN RESPONSE TO MARKET NEWS OR ECONOMIC EVENTS; HOWEVER, OUR INVESTMENT COMMITTEE EVALUATES AND REPORTS ON MARKET AND ECONOMIC CONDITIONS TO PROVIDE OUR INVESTORS WITH PERSPECTIVE AND TO PUT PORTFOLIO PERFORMANCE IN PROPER CONTEXT.
Successful investors are engaged in an ongoing practice of making trade-offs. Every one of us has a finite amount of money, so we must figure out for ourselves how much of our available cash we want to invest and where we want to invest it. Determining how much to put in stocks versus bonds is a vital decision, one that your financial planner should help you make with confidence, in alignment with your time horizon, goals, and emotional tolerance for risk.
For market-based portfolios like those Modernist manages, we need to recommend how much to invest in stocks and bonds for them to have a high probability of reaching their goals.
For long-term planning, placing most of our money in stocks can help fuel fast growth, but when stocks are gyrating up and down, it means less in cash and bonds to help stabilize the whole portfolio. Yet, placing all our money in cash and bonds is very unlikely to get us the growth we need and to outpace inflation, both of which we need to fund our financial goals (we’re looking at you Advanced Style.)
Yet, the trade-offs don’t stop there. A multitude of asset classes make up the very broad categories of stocks and bonds; the difference between achieving our goals or falling short is deeply influenced by the decisions we make in how much we allocate to each asset class (US vs. international, small capitalization vs. large, value vs. growth stocks, short duration bonds vs. longer loans, etc.) Fortunately, we rely on a sizable body of industry and academic evidence to make informed decisions about these trades-offs.
Today we’re going to dig into bonds: why we love them and which ones we love most (and show it by choosing them for our portfolios).
The bonds we want (and don’t want) in our portfolios
Academics evidence tells us to use stocks for growth and bonds for preservation and managing volatility. But, what are the tradeoffs between the type of bonds we can use in our portfolios?
Let’s start with the basics: a bond is simply a loan that an investor makes to an entity like a US or international company, governments like the US federal government, states, counties, cities, and even other countries. We can also buy bonds from a college or hospital. Really, any large institution that needs to raise money for growth can issue bonds.
Historically, stocks and bonds have grown over time, but bonds just haven’t grown as fast as stocks. Different types of bonds behave differently depending on market and economic conditions (some bonds have moved in the same general direction as stocks, while others have moved in the opposite direction). Because we want the bonds in our portfolios to hold their value, or even increase when stocks fall, we seek bonds that tend to move in the opposite direction of stocks.
Evidence shows us that the type of bonds we’d like to own are generally high-quality (loans issued by very strong borrowers like the US government) and short-to-intermediate-term (generally loans that get paid back in less than five years).
High-quality bonds are typically issued by stable governments with the power to repay them by raising taxes or by well-established companies that generate sufficient revenue and profits to service their debt. We tend to like short-to-intermediate-term bonds because you get your money back sooner, allowing you to reinvest in better rates, if they are available.
SO how did OUr bonds do in 2020?
In the first quarter of 2020, global stock markets fell hard on news of the COVID-19 pandemic, yet high-quality, short-to-intermediate-term bonds did what we wanted them to do. They generally held their value and, in most cases, went up in value.
Early 2020 was a perfect example of why we use these types of bonds in Modernist’s portfolios.
For our accumulating clients, having money in assets that go up when stocks go down gave us the ability to rebalance portfolios where appropriate, selling bonds that were worth more to buy stocks that were worth less. For our clients who were taking distributions from their portfolios, stable bond positions were ready to help us fund their monthly lifestyle expenses while avoiding selling stocks at lower prices.
As expected, not all bonds rose in value during the COVID-19 market decline of 2020. Investments like high-yield bonds (aka riskier borrowers), bank loans (aka floating-rate notes), and lower-rated investment-grade bonds fell in value alongside stock prices. These types of investments became more popular with investors over the past decade as interest rates stayed at historical lows, they “went chasing yield” by seeking higher interest rates from their bonds (which they had to take a lot more risk to get). Investors who pursued these types of riskier bonds saw everything in their portfolio decline at the same time, likely quite a disappointing experience.
What does 2020 mean for our bond allocations in 2021?
These types of trendy bond investments are one of the most concerning elements we see in prospective client portfolios, making us worry that their previous investment managers were ignoring academic evidence in favor of investing trends (like high yield bonds and active managers) that are unlikely to help their clients meet their goals.
As we enter 2021, the interest we earn from our bonds is still very low. While this might tempt some investors to explore taking more risk with their bonds, we urge you to remember that we do not buy bonds to produce income. We use bonds to protect your financial life plan and to offset the ups and downs of stocks. Even with low interest rates, those benefits still exist.
We remain proponents of using academic evidence to support each investment trade-off we make in our portfolios. In the case of bonds, the evidence still strongly supports the use of high-quality, short-to-intermediate-term bonds. In a total portfolio, these types of bonds play a crucial role in smoothing the bumpy growth of stock markets around the globe.