- Bonds continue to play an important role as diversifiers of portfolios.
- High-quality bonds and short-duration bonds can help preserve capital while managing risks from potentially rising interest rates.
- Investors can select from a variety of approaches to manage their bond portfolios despite uncertainty about interest rates.
On July 19, 2021, the S&P 500 suddenly dropped 3% in a single day and investors got an attention-grabbing reminder of how bonds still play a critical role in their portfolios, even while interest rates are low. For months, rates had been near record lows while the S&P 500 had marched steadily higher. Even the Financial Times was calling the markets “boring.” Then stocks abruptly sold off and bond yields fell. Those falling yields meant that the bonds’ prices were rising and investors with fixed income assets in their portfolios could take comfort in the fact that the impact of falling stocks on the value of their portfolios was being offset by gains from their bonds.
It was an example of bonds doing what they have long done so well: Helping to blunt the impact of stock volatility. “Historically, bonds are less volatile than stocks,” says bond portfolio manager Jonathan Duggan of Fidelity Strategic Advisers, LLC. “They provide ballast for a well-diversified portfolio, and that’s why I believe bonds are a very important component in investors’ portfolios, even though interest rates are low.”
The potential benefits of bonds
The protection that bonds can offer when stocks turn volatile is one reason why in 15 of the 18 quarters since the start of 2016, bond mutual funds and ETFs have attracted more money from investors than stock funds, even while interest rates have remained low and stock prices have risen. Even if bonds generate less income than they once might have due to low rates, bonds are still essential building blocks for most portfolios. That’s because they offer a way to potentially preserve wealth, and diversify portfolios to help ride out stock market storms.
As Ford O’Neil, manager of Fidelity Total Bond Fund (FTBFX), puts it, “When you think about investing in bonds, you’re likely interested in preserving capital and the diversification benefits relative to some of the assets in your overall portfolio.” Diversification matters when volatility inevitably returns to stocks and adding bonds to a portfolio can provide a counterweight. Keep in mind, though, that diversification and asset allocation do not ensure a profit or guarantee against loss.
While capital preservation may not be as inspiring as rising stock prices, it may be at least as important for many investors. As baby boomers exit the workforce and Generation X eyes retirement on the horizon, many may be more concerned with holding on to what they have than with pursuing growth.
But what about rates?
Even investors who understand the usefulness of bonds for diversification may struggle to reconcile that usefulness with the low yields currently available from most bonds. Those yields reflect the Federal Reserve’s March 2020 decision to cut the federal funds rate by 100 basis points and its pledge to keep rates low until 2023 at least. Meanwhile, the yield on 10-year Treasury bonds dropped from 2% to ½%. That matters because today roughly half the yield of a typical corporate bond is determined by Treasury 10-year rates. Low rates also limit the amount that bond prices can rise. For prices to rise, rates need to fall as they have been since 1981, but with yields near zero, they aren’t likely to fall much further. Central banks in Japan and Europe have lowered their rates below zero, but the Fed’s leaders have said they don’t believe negative interest rates are right for the US. Instead, the Fed pledged to keep rates low, even as economic growth and inflation increase, a historic change from its traditional use of rate increases to keep inflation under control.
Source: Strategic Advisers, Inc. Hypothetical value of assets held in untaxed accounts of $100,000 in an all-cash portfolio; a diversified growth portfolio of 49% US stocks, 21% international stocks, 25% bonds, and 5% short-term investments; and all-stock portfolio of 70% US stocks and 30% international stocks. This chart’s hypothetical illustration uses historical monthly performance from January 2008 through February 2014 from Morningstar/Ibbotson Associates; stocks are represented by the S&P 500 and MSCI EAFE Indexes, bonds are represented by the Barclays US Intermediate Government Treasury Bond Index, and short-term investments are represented by US 30-day T-bills. Chart is for illustrative purposes only and is not indicative of any investment. Past performance is no guarantee of future results.
Now, though, with inflation rising sharply, the Fed may be rethinking that policy. Projections from the Fed’s June meeting suggest it could raise the federal funds rate twice by the end of 2023 but rate increases could also come as early as 2022. However, neither those projections, nor the fed fund futures market suggests the rate will rise above 1% in the next 2 years.
Rates and risks
Rising rates is one of the key risks that bond investors must consider. Other risks, such as the possibility that an issuer will default on making scheduled interest payments, can be largely avoided by simply buying only bonds with high credit ratings. However, when rates rise, the market value of many bonds is likely to decline, regardless of their credit quality. To understand how susceptible a bond may be to interest rate risk, experienced investment managers look at the bond’s duration, a measure of how likely its price is to be affected by changes in interest rates. Investing in bonds with shorter duration can be a way to help reduce the interest rate risk facing the bond portion of your portfolio. Rate risk may also be managed by holding individual bonds to maturity, as in a bond ladder.
A core strategy
While rate uncertainty may complicate bond investing, it is not a reason to pass on the benefits that bonds can offer. Also, as Duggan points out, the prospect of rising rates signal that the economy is strengthening, which may benefit bonds. “Over the longer term, higher Treasury interest rates also help benefit returns, as bond issuers have to offer a premium over Treasury rates to entice investors to buy their bonds,” he says.
If the traditional and enduring benefits of bonds appeal to you, adding what is known as a core bond position to your portfolio could be a good first step to consider. A core bond portfolio is a selection of bonds with high credit quality. Often, a core bond portfolio holds bonds issued by the US government and corporations with high credit ratings and regular interest payments. For example, O’Neil and his team manage the Fidelity Total Bond Fund with the goal of maintaining 2 roughly equal-sized allocations, one to US Treasury bonds for the relative stability they provide, and another to investment-grade corporate bonds for the higher yields they may offer.
Because core portfolios generally emphasize capital preservation, rather than maximizing yield, they are less likely to include big allocations to higher-yielding but riskier bonds issued by companies or governments with lower credit ratings. Fidelity Total Bond Fund, for example, may invest no more than 20% of its assets in higher-yielding bonds.
The mix of bonds in a core portfolio includes a large number of issuers and a wide range of yields and dates when the bonds mature. Finding and combining those bonds in a way that delivers the stability and yield that you seek is a process that rewards skill and painstaking research. Depending on how much of that you possess or want to do, you can choose from among 3 strategies: buying a mutual fund or exchange-traded fund (ETF), assembling a portfolio of individual bonds, or having a professional build and manage a portfolio of bonds for you in a separately managed account (SMA).
Investing in a bond mutual fund or ETF
Buying shares of a bond mutual fund or ETF is an easy way to add a bond position. Bond funds hold a wide range of individual bonds, which makes them an easy way to diversify your holdings even with a small investment.
An actively managed fund also gives you the benefits of professional research. For example, the managers can make decisions about which bonds to buy and sell based on huge volumes of information including bond prices, the credit quality of the companies and governments that issue them, how sensitive they may be to changes in interest rates, and how much interest they pay.
Not all bond funds are actively managed. Investors who seek bond exposure in a fund can also choose among exchange-traded and index funds that track bond market indexes such as the Bloomberg Barclays Aggregate Bond Index.
Here’s more about the difference between investing in bond mutual funds and individual bonds.
Investing in individual bonds
If you have enough money and believe you have the time, skill, and will to build and manage your own portfolio, buying individual bonds may be appealing. Unlike investing in a fund, doing it yourself lets you choose specific bonds and hold them until they mature, if you choose. However, you still would face the risks that an issuer might default or call the bonds prior to maturity. So this approach requires you to closely monitor the finances of each issuer whose bonds you’re considering. You also need enough money to buy a variety of bonds to help diversify away at least some risk. If you are buying individual bonds, Fidelity suggests you spread investment dollars across multiple bond issuers.
Fidelity offers over 70,000 bonds, including US Treasury, corporate, and municipal bonds. Most have mid-to-high quality credit ratings that would be appropriate for a core bond portfolio. Investors can use online tools to help screen for available bonds, build a bond ladder, set up alerts, and analyze their holdings with Fidelity’s Fixed Income Analysis Tool. Learn more about individual bonds.
Separately managed accounts (SMAs) combine the professional management of a mutual fund with some of the customization opportunities of doing it yourself. In an SMA, you invest directly in the individual bonds, but they are managed by professionals who make decisions based on factors such as current market conditions, interest rates, and the financial circumstances of bond issuers. Find out more about separately managed accounts.
Whatever your bond investing goals, professionally managed mutual funds or separately managed accounts can help you. You can run screens using the Mutual Fund Evaluator on Fidelity.com. Below are the results of some illustrative mutual fund screens (these are not recommendations of Fidelity).
Taxable bond funds
- Fidelity® Total Bond Fund (FTBFX)
- Fidelity® Investment Grade Bond Fund (FBNDX)
- American Funds Corporate Bond Fund (BFCFX)
- MFS Corporate Bond Fund (MFBFX)
- iShares Core US Aggregate Bond ETF (AGG)
- Fidelity® Total Bond ETF (FBND)
- Fidelity® Investment Grade Bond ETF (FIGB)
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