Bond Market Update
After a good year for bonds in 2017, with total returns of 4–5%, it has come as a bit of a surprise to see bond returns negative year-to-date in 2018.
After years of ultra-low yields, short-term bonds are finally paying over 2%, thanks to the Federal Reserve’s ongoing interest rate hikes. Intermediate-term and long-term bond yields have also risen. As interest rates rise, existing fixed-rate bonds lose value, but future return expectations rise. We expect 3-5 year forward bond returns to be about 1% higher than we would have expected a year ago.
It’s worth noting that our clients’ bond mutual funds are generally performing a little better than the Barclays US Aggregate bond index, which is down over 1%. This is primarily because we have cautiously avoided long-term bonds, which are more interest rate sensitive and experience greater price fluctuations (volatility).
International bonds, especially those in emerging market countries, have suffered the most in 2018. A strong U.S. dollar and various idiosyncratic risks (i.e., trade, political) have weighed on many foreign currencies this year, which reduces the return to a U.S. investor. We think the underperformance of emerging markets is overdone and will eventually recover.
One way to view the bond allocation in your portfolio is as a sort of insurance policy. The bonds protect against stock market declines, as evidenced in the charts below. The first shows that over the past 10 years, monthly returns of U.S. stocks and U.S. bonds have been positive on average. However, when stocks have had a bad month, the bonds have held up well. The second chart shows only the downswings of U.S. stocks and bonds since 1990 to illustrate how much worse a bad year for stocks is compared with a bad year for bonds.
As we approach the 10-year anniversary of the Lehman Brothers bankruptcy and the worst moments of the 2008–2009 recession, memories of how bad they were are starting to fade away and greater risk taking is becoming popular again. Although the current U.S. economic expansion may continue, we favor a balanced approach that matches each client’s risk tolerance to an appropriate portfolio. We think investing in bonds/bond funds is the best way to manage the risk of an investment portfolio.
Feel free to give us a call at 714-738-0220 if you would like to discuss this further, and we would be happy to go into more detail for you.