Our firm recently increased the exposure to bonds in our client portfolios, despite the dire warnings of many analysts and pundits who have been warning that interest rates are bound to rise, causing a crushing bear market in bond prices. In our view, it is not quite that simple.
Even the most sophisticated investors can be confused about how bonds work, and I have learned that there is no more misunderstood asset class.
Many investors mistakenly assume that bonds are “fixed” investments, that their return can only come from the receipt of the fixed cash interest payments their bonds generate. In fact, bond market investments can also experience capital appreciation in addition to income payments, just like stocks. Consider the Exchange Traded fund with the ticker symbol TLH, which tracks the behavior of the 10-20 year Treasury bond market. Despite the fact that 10 year Treasury yields have been below 2% all year this year, this fund has experienced price appreciation of over 6.5% so far in 2016! Or look at the ETF ticker IGOV, which tracks the international Treasury bond markets. Despite a current yield below .2%, this fund is up over 10% on a price basis this year thanks to plunging interest rates in Europe!
Many also make the mistake of assuming that higher interest rates are always bad for bond prices. This simplistic rule is also not necessarily true. In fact, there are several areas of the bond market which can perform quite well when interest rates are rising. For example, high yield or “junk” bonds may perform well in a rising rate environment, as it is often true that rates may be rising because the economy is improving, which means that credit quality may be improving, causing low rated bonds to become upgraded. Even Treasury bonds do not necessarily suffer when rates go up: Between 1940 to 1980 interest rates rose from 2% to 15%, but an investor who owned constant maturity 10 year T-Bonds during that time still doubled their money over those years.
Finally, many mistakenly believe that bonds and stocks can’t go up at the same time, and that stocks always return more than bonds over the long run. In fact, in the last 15 years it has been quite a race, as they have both increased, but bonds have the edge:
The bond market is an extremely complex and multifaceted place. Economic developments, interest rate movements, and currency changes can all affect different parts of the bond market in different ways. Treasury bonds will act much differently than junk bonds which will act differently than International bonds. The one thing we can generally count on is that there will always be money to be made somewhere in the bond market!