An investor recently asked why we would own bonds in a rising interest rate environment. Why not just move that portion of the portfolio to cash or some other asset class that has exhibited less interest rate sensitivity? This is a great question, so let’s explain why selling out of bonds likely poses more risk than staying in them over the long run.
The table below shows that asset class selection explains over 93% of long-term performance. Security Selection, or “stock picking,” is somewhat additive, but without the asset allocation in place, it’s an uphill battle. Market timing is a waste of time.
Source: Brinson, Hood and Beebower, "Determinants of Portfolio Performance"
It’s no different than those three sacred rules in real estate. Pick good locations and you’re probably going to do ok. That’s why we spend most of our time looking for good neighborhoods to invest.
We build investment strategies to target various return objectives (growth, income, etc.) and levels of risk (conservative all the way to aggressive). In doing so, we are big believers in diversification by investing in a wide range of asset classes including stocks, bonds, gold, real estate, etc.
Mixing asset classes together at various proportions is how we create a baseline for each risk tolerance and return objective. For example, if we want to build a portfolio with “moderate” risk (somewhere between conservative and aggressive), we may target 40% or so in bonds. We derive this “target allocation” by looking at historical volatility, the correlation between bonds and other asset classes, and the expected return over a multi-year period.
But that 40% is not set in stone. Economies and markets evolve, and we feel that maintaining a “static asset allocation” that ignores these inflection points risks taking investors off track slowly over time.
Instead, we establish guardrails around this 40% to increase or decrease the allocation up to a point. Let’s say guardrails are set at 15%, so the range for bonds would be 25% - 55% of a portfolio. If we are bullish on bonds, then we may move from 40% to 50%. The opposite if we are bearish.
But we almost never exceed guardrails because first and foremost we want to ensure the portfolio maintains its risk profile. If we sold all bonds, then we run the risk of breaking our risk mandate and adversely impacting the financial plans that are using this strategy.
For example, if we moved all 40% bonds to cash, it’s no longer a moderate risk portfolio – most likely a more conservative one – and that could risk the long-term goals of an investor if/when the bond market recovers.
Said another way, since it’s impossible to time markets (nor is it additive over the long run per the table above), guardrails hedge the risk of us being wrong.
Now, within that 25 - 55% bonds, we try to generate as much return as possible. Back in early 2020, we upped several allocations to bonds and went long duration within those allocations because we felt the Fed was going to keep its bond buying program intact for some time.
Later that year, we began to cut duration aggressively and the overall allocation to bonds in many instances, and we have remained defensive ever since. But we never for once considered selling all bonds because that would have risked causing more problems than solving.
The bottom line
Most investors own bonds for income and diversification, and just because rates are rising doesn’t imply that every corner of the bond market is doomed. Regarding our strategies, most bonds continue to pay their coupons on time with low risk of default. Furthermore, we mostly own bonds through Exchange Traded Funds (ETFs), which offer tremendous diversification that shield us from a single credit default.
We also feel confident that the bond market will find its footing. The chart below shows that risk-free yields have surged higher this year, and at some point, they will likely become too attractive for investors to ignore. The challenge is we have no idea when that will happen. It could be next year when the Fed expects to stop raising rates, or it could be next week.
Source: Bloomberg, RWP analysis
But what I’m very sure of is that I don’t want to cause too much damage by failing to time re-entry properly. Because recoveries tend to go unnoticed until they’re well underway. It’s usually two steps forward, one step back. Three steps forward, two steps back. If we’re late when our bond allocation is still above our guardrail, it’s way easier to recover than if we had no bonds at all.
Lastly, cash investments strike at the heart of the paradox. What is viewed as “safe” now appears quite risky to those investors worried about outliving their nest egg. Bank accounts pay nothing, and even higher yielding cash investments top out at 2.8% right now1.
That means locking in a big loss against inflation, and while bonds may be down more on paper right now, many are still paying yields well above cash. Those bonds trading at a discount will mature at par (barring default) and may even add to the total return.
Said another way, would you sell a rental property with a good tenant who paid on time simply because housing prices took a hit? Or would you rather collect the rent check and wait for the market to recover?
The bottom line is that this year has been the toughest in modern history for bonds, but don’t throw the baby out with the bathwater. Bonds remain both a vital tool for asset allocators and a source of income for those who need it.