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Why Own Bonds?

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The Foolish Fish

In a huge pond lived many fish. They were arrogant and never listened to anyone. In this pond, there also lived a kind-hearted crocodile. He advised the fish, “It does not pay to be arrogant and overconfident. It could be your downfall.” But the fish never listened to him. “There is that crocodile, advising us again,” they would say. One afternoon, the crocodile was resting beside a stone near the pond, when two fishermen stopped there to drink water. The fishermen noticed that the pond had many fish. “Look! This pond is full of fish. Let’s come here tomorrow with our fishing net,” said one of them. The crocodile heard this. He slipped into the pond and went straight to the fish. “You had better leave this pond before dawn. Early morning two fishermen are coming with their nets,” warned the crocodile.

But the fish just laughed and said, “There have been many fishermen who have tried to catch us. These two are not going to catch us either. Do not worry about us, Mr. Crocodile.” The next morning, the fishermen came and threw their net in the pond. Very soon all the fish were caught. “If only we had listened to Mr. Crocodile. He had only wanted to help. For our arrogance we have to pay with our lives,” they said. The fishermen took the fish to the market and sold them for a good profit.[1]

  

Why Should I Own Bonds?

Over the last few years, low yields on bonds and the direction of interest rates have been the source of much investor anxiety. Many investors knew interest rates had to increase and feared that in combination with low yields, it would spell for trouble bonds. 

As such, many asked a variation of the following questions:

  • With rates going up bonds will lose money; so why would we own them?
  • With yields so low, and net of an advisory fee the yield is even less, why would we own bonds?
  • Shouldn’t we switch to other investments that yield more than bonds?

Basically, the question is, in this environment, why should I own bonds? 

Well, so far in 2016 interest rates are not rising, and neither are stocks. The yield on the ten-year Treasury bond dropped 18% (2.26 to 1.93) while US stocks (S&P 500 Index) dropped around 5% in January. Last month highlighted why bonds are still an important part of a well-diversified portfolio.

In a low return environment, the temptation is to “reach for yield.” Meaning to look for investments with a higher yield (either interest or dividends). And because there are no free lunches when investing, doing so means taking on additional risk. The most common ways in which people “reach for yield” is moving into high-yield bonds—the debt of more leveraged and (or) less financially viable companies—or moving into high-dividend stocks, somehow viewing each as a suitable substitute for bonds. 

Let’s take a look how this would have worked over the last two bear markets—The “Tech Crash” from Sept ’00 – Sept. ’02 and the Global Financial Crisis from Nov. ’07 – Feb ’09. 

 2000_Fixed_Income_Returns.png

During the “Tech Crash” of 2000, the S&P 500 index dropped nearly 45% over two years. The Tech-heavy NASDAQ index was down even more —dropping 72% over the period. 

Cleary any diversification out of these two areas would be great. The typical “yield” diversifiers did the following: 

  • Barclays Aggregate (A mix of government and corporate bonds in the US) up 23.5%
  • Treasury bonds up 27.5%
  • High Yield Bonds down 8.7%
  • And, High Dividend stocks down 13.3%

And let’s take a look at 2008 during the global financial crises (GFC).

2008_Fixed_Income_Returns.png

During the GFC, these “yield” investment performed even worse than during the “Tech Crash”. While Treasury bonds and the Aggregate bond index performed well over the period High Yield bonds and High Dividend stocks did not.

  • Treasury bonds up 15.6%
  • Aggregate bond index up 6.1%
  • High Yield Bonds down 25.6%
  • And, High Dividend stocks down 50.3%

 

Bear markets highlight the value and the important role that bonds play in a portfolio. The start to 2016 is a reminder that while bonds do have a low yield currently, they do still play an important part of building a diversified portfolio. While reaching for yield may seem tempting it can disappoint just at the moment the protection is needed. 

As the story of the foolish fish states “It does not pay to be arrogant and overconfident. It could be your downfall.” Investors would be wise to remember this when they feel the need to reach for yield.

 

 

 

 

[1] The Foolish Fish from http://www.thehindu.com/features/kids/foolish-fish/article3906806.ece?css=print

 

 

Click here for disclosures regarding information contained in blog postings.
Cordant, Inc. is not affiliated or associated with, or endorsed by, Intel.

Published on February 04, 2016

Isaac Presley, CFA

Isaac Presley, CFA

Isaac Presley is Director of Investments for Cordant, a wealth management firm serving current and former Intel employees. To learn more, you can read Isaac's full bio.

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