As an investor, you’ve likely noticed the current trends with interest rates and are questioning whether bonds are a smart investment. Bond prices and interest rates have an inverse relationship, so if rates rise holding excess cash instead of investing in bonds may seem reasonable.
Even in the current market environment, with low and potentially rising interest rates, it’s prudent to continue viewing bonds as a viable investment option. Bonds serve an important purpose for long-term investors. By allocating a certain portion of your portfolio to bonds, you benefit from an asset class that will help protect you from stock market corrections.
In this Insight, I’ll explain some reasons why bonds remain an effective investment strategy.
When all other factors are equal, as interest rates go up, bond prices go down. The reason for this inverse relationship is that when interest rates increase, new bonds offer higher coupon payments. Existing bonds with lower coupon payments must decline in price in order to be worthwhile investments to would-be buyers.
Long-term bonds are more impacted by interest rate changes than short-term bonds. There are two reasons for this from a long-term bondholder perspective: (1) more time until maturity which is when the quoted bond value is received and (2) more interest payments which are reinvested at the then higher/lower prevailing interest rate. At Wealthstream Advisors, we believe in investing in a laddered portfolio including short, medium, and long-term bonds to help you hedge against interest rate risk while enhancing return.
In today’s environment, when interest rates are low and potentially increasing, investors are hesitant to invest in bonds. But there are still several reasons why investing in bonds is a smart move.
Ask yourself: Will interest rates continue to rise? As much as we like to predict what the future holds for financial markets, the truth is we just don’t know what will happen with interest rates. In fact, economists are notorious for botching their interest rate predictions. For 10-year Treasury bonds, economists have been consistently overestimating future interest rates since the mid-1990s1.
Predictions have a spotty track record, but perhaps actions related to the Fed are more reliable? The answer is no because the Fed only has control over the short end of the yield curve. Since the yield curve consists of various rates at various maturities, the markets determine the rest of the curve.
Even though bond interest rates are at historic lows, you can still rely on them to provide a relatively secure income stream.
When looking at bonds as a possible investment option, it’s easy to overlook what they’re best at doing: protecting your portfolio from stock market corrections. To look at a recent example, consider the last big stock market correction (February 19th to March 23rd, 2020). During that span, an all-stock portfolio would have taken a 35% dip. A portfolio with a 60/40 ratio of stocks and bonds would have only declined by 24%. Data source: Russell 3000 Total Return Index for Stocks and Bloomberg Barclays US Aggregate Total Return Index for Bonds.
If interest rates go up and the bonds in your portfolio lose value, it doesn’t mean your long-term outlook is worse. Remember, bond prices only indicate the amount you’ll receive if you sell your bonds on the market. You’ll still receive your coupon payments on top of the bond’s face value when it reaches maturity. If you plan on holding on to your bonds for their entire duration, present-day dips in value are only temporary.
Interest rate increases can be a positive for long-term performance. As your bonds produce income, you can use that income to reinvest in more bonds at the higher current interest rate. The end result? Higher returns.
The Bottom Line
At Wealthstream Advisors, we hear from many clients who are worried about investing in bonds due to low and rising interest rates. However, we maintain our belief that for long-term investors, bonds still play an important role in portfolio optimization.
If you’re questioning whether investing in bonds is a good idea, remember that bonds serve a key purpose as stabilizers in a long-term investment portfolio. If you want to learn more about how bonds can help you reach your personal financial goals, schedule a free consultation with a Wealthstream financial advisor.
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