The Coronavirus has changed our lives – what we do, where we go, and how we interact. In fact, there’s increasing evidence that COVID could fundamentally change how we invest our money in the future.
Many investors build a portfolio with a mixture of stocks and bonds. Stocks deliver long term returns with volatility while bonds provide income and safety. Mix the two, and you get a portfolio that provides growth, income, and safety.
This strategy has been incredibly successful. Stocks have delivered an average return of 10% per year over the long run, while bonds have provided an average return of 5.3% per year going back to 1926. Mixing a portfolio of half stocks and half bonds would have provided an average yearly return of over 7.6%, not a bad return for a fairly conservative portfolio.
As COVID began taking its toll on the U.S. economy in March, the Federal Reserve began lowering interest rates to zero. It also started a massive bond-buying program to help the investment markets and economy. These two directives pushed interest rates to historically low levels. At the time of this writing, the Vanguard Total Bond Market Index is yielding 1.1%, a far cry from the 5.3% historical return.
Concerns Going Forward
Bonds provide income and not much more. Sometimes you can get price appreciation when interest rates go down, but that is often temporary as the price goes back to par upon maturity. With the current yield on the bond market index at 1.1%, you will need some serious appreciation to get to the historical return of 5.3%.
The problem is that yields are at historically low levels, and the Fed has indicated no interest in creating negative yields. The Fed also made a major announcement on August 27 that essentially stated they would be slow to raise rates, compared to the past, as they want a slightly higher inflation rate. This statement means it is likely that interest rates will stay low, regardless of the economy’s strength. So investors buying bonds today should expect very low returns, based on historical norms, unless rates change meaningfully.
Another concern is that bonds have historically gone up in value when the stock market fell. This is mainly due to interest rates dropping as the economy weakens. If interest rates are near the bottom and have limited room to fall, their ability to go up significantly during the next downturn could be impacted. If this is the case, you should expect a balanced portfolio to be a little more volatile as bonds’ ability to help during the next stock downturn may be muted.
What To Do
Bonds provide a meaningful benefit to a portfolio. They are a source of stability when the stock market declines, and they provide income and liquidity when you need it. Bonds will still provide these benefits, except the income contribution may be much smaller going forward.
Rethinking how you use bonds in your portfolio may be appropriate. You could buy bonds that provided safety, liquidity, and income all in one in the past. That seems less likely as we go forward.
You may have to view bonds (or other bond-like investments) in different ways. Maybe you have bonds that provide safety and liquidity, but little income. Or, you could have bonds that provide decent income, but perhaps aren’t as safe or liquid. Combining these strategies may allow you a higher yield and keep liquidity and safety available to you when needed.
What Not To Do
The action to avoid is chasing yield. If the bond market is now yielding 1% and you build a bond portfolio yielding 5%, there is a very good chance you are taking on significant risk in your bond portfolio. Add that to the volatility stocks give you, and you have a combined portfolio that may be too risky for your comfort during the next downturn.
Rethink what bonds mean for your portfolio and breakdown what you own and why you own it. As you adjust your portfolio, think about what you are buying and what purpose it will serve going forward. There will be tradeoffs to make. Understanding that you can’t have safety, liquidity, and income from the same bonds will keep you from being disappointed in your portfolio down the road.
Ryan Collier, CIMA, is the Director of Investment Management with Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. For more information, visit their website at www.bedelfinancial.com or email Ryan at firstname.lastname@example.org