The Myths of Bonds

150 150 Northstar Financial Planners

Bonds have a place in just about every portfolio. At Northstar, we prefer to buy bond mutual funds rather than individual bonds for many reasons, but they serve the same purpose: To lessen the high volatility associated with equity investing.

Unfortunately, many bond investors have different goals in mind, and those goals are often based on mistaken beliefs regarding bond markets. Here are some of the more common widely-held misconceptions, or myths of bonds:

  1. The primary function of bonds is to provide income. It’s a wonder anyone could have ever come to such a conclusion – okay maybe, possibly, the confusion has arisen because bonds are often referred to as “fixed income” investments. Hmm, actually that kind of makes sense.

Thinking of bonds as income generators made more sense back in the 80’s when interest rates were above 10%, but even then, the income generated from bonds was taxed at a higher rate than capital gains from long-term investing. That meant (and still means) your real bond returns (after taxes) are a lot lower than the stated interest rate.

And in a long-time environment of low interest rates, bonds have hardly been reliable income producers. Retirees who have relied on a bond portfolio for income have either had to extend bond maturities, buy bonds with lower credit ratings, or just get by on less income. Three terrible options.

  1. Rising interest rates are bad for bonds. As with many financial questions, the answer depends on who you ask. If you are concerned about the value of your bond and sell because the price has fallen, then yes, rising interest rates are bad for you. But if you hold the bond until maturity, the bond price will return to its face value.

The same logic holds for bond funds, though the math is not as simple. Short-term investors, otherwise known as “non-investors,” will indeed get punished when they dump their bond funds after an interest rate increase. But for the investor who wisely holds his funds, the yield will return. Do you have to wait for interest rates to fall for that to happen? Not necessarily. It will happen as the bond fund manager redeems maturing bonds within the fund and buys new ones at the higher rate.

This chart from Vanguard illustrates the idea, given a bond fund yielding 2.3% with a duration of 5.6 years:

Table 1: Change in Bond Fund PricesChart 1

Let’s take a 3% interest rate increase. That is a pretty big rise and will immediately lower the price of the bond by 13%. But within a year, as the fund manager replaces old bonds with new ones with much higher yields, the price of the fund will go up, and will now only be down 4.3% from where it began. Within 4 years, the price will be higher than at the start.

So patience and discipline reward us on the bond side of our portfolio, not just the equity side.

  1. Active bond management is needed when rates change. Aah, wouldn’t the supporters of active management be thrilled if this were true? After all, they’ve been beaten up from just about all sides (academia, the media, investors and other advisors) on the equity side that the active management story is a failure. Well, maybe they can cling to bonds to redeem themselves.

Sorry active managers, there’s no proof it works on the bond side either. As we saw in the previous point, a simple process of replacing maturing bonds with new ones is what recovers the fund value. Particular bond selection is not important – it is assumed the new bonds are of similar credit quality and duration to the old ones.

Active bond fund managers are vulnerable to the same problems that plague equity fund managers attempting to beat the market: They have to be right twice. They have to know when rates are going to rise so they can shift their funds out of bonds, and know when they are going to decline so they can get back in.

Just look at the recent history of bond interest rates and ponder if an active approach would have done well. The Federal Reserve signaled in 2013 that the program known as Quantitative Easing (QE) or bond buybacks, was going to end in 2014, which led the Wall Street herd to predict interest rates would rise. In fact, 43 out of 44 economists surveyed by The Wall Street Journal predicted the 10-year Treasury rate would increase.

Guess what? It didn’t happen. In 2014, interest rates declined even more. Some years ago, Karolyn Mitchell and Douglas K. Pearce, professors at NC State University documented that economists correctly predicted interest rate directions far less than half the time. You’d be better off flipping a coin.

And therein lies the problem for active investment. They’d be better off using their expertise to figure out what they think interest rates will do, then doing the opposite. Would you invest with a fund manager employing that strategy?

Once we dispel the mythology around bonds, we are led to the same conclusion we’ve long held on equities: diversify, stay invested, and don’t worry about the short term noise.


Steve

Adapted from a FinancialPlanning.com article, “4 Big Myths about Bonds,” by Allan S. Roth, July 27, 2015.
Past performance is not a guarantee of future results. Diversification does not eliminate the risk of market loss. This content is provided for informational purposes, and is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products or services.

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