In recent years, looking at the performance of the S&P 500, it has become far more lucrative to focus on the equities in your investment portfolio. According to https://www.forbes.com, in just about a decade, the S&P 500 has seen a four times growth while in comparison, the performance of bonds has been lackluster with quality bonds returning only 2%-3% even in recent times. Even over the long-term, stocks have delivered a better performance than bonds, outpacing them averagely by 3% per annum. Given this context, it is not unnatural for questions to arise on the necessity of staying invested in bonds at all.
Bonds Help to Manage Risk
Among the strongest arguments for keeping bonds in your investment portfolio is that they help to manage risks. When the stock markets are rising, it can be very easy to forget the pain when the stocks take a tumble, as they are prone to do once in a while. It is not uncommon for stocks to lose half their value or perform even worse in a strong bear market. As rare, as such incidents are it is in these times that bonds become more attractive. Historically it has been observed that in times of financial crisis, government bonds have a tendency to rise. Savvy investors also use bonds to raise cash to invest in shares that have become more attractive due to the bear hug.
Rising Rates and Bonds
As attractive as bonds are in a recessionary economy, many people ask whether it makes any sense to stay invested in bonds when the market is consistently rising. According to experts, the important thing to consider is the rate of increase of the interest rate.Bonds tend to lose money with the increase in interest; however, the interest payment received on bonds can compensate for the decline in value a certain extent. For example, any decline in the value of the U.S. 10 Year Treasury Bond that has a current yield of 2.8% would need to be more than the annual interest payment for it to have any effect.
It is possible to calculate by how much the rate of interest would need to change with a concept known as modified duration. According to the formula, the duration is 8.5 years for the 10-year Treasury bonds, which means that the bond’s value will decline by 8.5% for every 1% rise in the interest rate. With a couple of rate hikes expected, investors can expect their 10-year bonds to lose around 2%-4% everything else remaining unchanged, so it may seem to be a rather unattractive prospect. It, therefore, does not seem to make sense to take a risk when apparently money is going to be lost. Visit nationaldebtreliefprograms.com to know more about how interest rates on government bonds have moved over the years.
Among the things, that you need to consider is thatgenerally, market expectations seem to factor in the rising interest rates, and thus the current bond prices are similarly adjusted. If the interest rates were rising continuously, it would seem that the bond prices would already have some cushioning built in to accommodate that phenomenon. Due to this padding in prices of bonds, every rise in the rate of interest may not directly affect the bond pricing. It is only when the interest rates rise faster or more than what is expected that the bondholders should be worried. As things look right now, it does not seem that there will be any upheaval in the interest rate.
The Impact of Recession
Another critical factor that affects bond prices is a recession, which has been seen to occur every few years in the United States. Since it is about a decade since the last recession, which is a fairly long time though recessions don’t follow regular time schedules and also because the yield curve is flat, some people are getting worried that the next recession may be around the corner. When a recession sets in or in the preceding months, the stock market can start falling. With the stock markets being currently quite buoyant, the signs are not encouraging too as the fall can be even more rapid if the economy shrinks. When corporate profits fall the share prices are likely to decline fast and the effect will be more pronounced since the current valuations are quite high.
Government bonds become more attractive to own during recessionary periods since it is quite unlikely that the government will fail to pay the interest. However, corporate earnings, dividends, and share prices are very likely to plummet albeit temporarily. Even though bonds will not rise too much due to the impact of the recession, the gap between the bonds and equity is so large that bonds can look very attractive indeed. Even though it can be difficult to predict the next recession, it is very clear that we have not had one for a very long time and the economy is perhaps close to its maximum capacity. While the booming economy is good news in the short-term, it also means that there is less chance for it to grow too much anymore. When the rates are rising as they are now, it does not make sense to hold bonds, however, since there are clear indications the economy could slump soon, having bonds in the investment portfolio can be very useful.
Since forecasting the direction of the movement of the economy can be quite difficult, it makes good sense to have assets in the portfolio that balance each other. Bonds always have been perceived as a good pairing for stocks as they are able to hold their value even when the stock valuation declines. It is not a good investment policy to have a portfolio that is only stock or only bond – a middle path is always more stable.
Whether to stay invested in bonds really depends on whether you are able to judge the timing of the next recession. Given the rising interest rates as of now holding bonds may not make good sense but if you are confident that the specter of a recession is looming, you will be glad that you have some bonds to give stability to your portfolio.