The Magic of Bonds

Friday Reflections | August 7, 2020

The Magic of Bonds

The market moved steadily higher again this week. News from today’s unemployment report offered a positive surprise as the official rate ticked down to 10.2%, despite many unemployment statistics remaining near record levels.[1] The recent national surge of coronavirus cases has slowed slightly. Second quarter corporate earnings have also continued to be stronger than expected with 84% of companies beating estimates, but S&P earnings overall are still down more than -35% versus last year.[2] All this, paired with tentative optimism on stimulus negotiations, have led equity prices higher – but more cautionary moves in bond and gold prices reveal an underlying distrust of the equity rally.

Financial news places virtually all attention on the stock market. Stocks have a whiff of opportunity about them. They increase and decrease in price more dramatically, giving what is often an illusion of actual dramatic change in value. Equity market prices are routinely seen as a current barometer of the broad global economy; in fact, they represent investors’ expectations for their future value. This makes equity prices a leading indicator of an imagined future to come, rather than a reflection of our current economy.

The global bond market is actually 50% larger than the global stock market,[3] despite getting a lot less ink and screen share in the press. Bonds can play many roles in individual and institutional portfolios; we value them primarily for improving stability and – perhaps less intuitively – as a tool to enhance future growth. Right now, bond prices are headed higher, which means there is increasing demand for stability, and many investors are opting to wait out upcoming volatility in the stock market.

For people navigating retirement, one significant psychological transition is the shift from the experience of a steady stream of earned income to a new reliance on a smaller stream of pension or Social Security, supplemented by withdrawals from savings. Decades of discipline to never touch one’s pool of savings are hard to reverse, and clients often experience stress when they tap these accumulated reserves. This can be doubly distressing when a stock portfolio swoons right after that moment of retirement.

Bonds cushion a portfolio from dramatic downside in stock prices. If you are a stockowner, then you own a small piece of a company, and the value of that investment varies with the fortunes of the company. If you loan the company money, though, as a bondholder, you are likely to experience considerably less volatility in the value of your investment. Bond interest and principal will always be repaid before stockholders receive their capital back. Unless circumstances are really dire, bond prices will be fairly resilient, and often move in the opposite direction to stock prices.

Knowing that your funds will be there when you need them has immense value – whether that need is a predictable monthly cost or the often unpredictable nature of home repairs or medical expenses. Beyond the psychological value, the benefit is also mathematical. Said differently, we are talking about the value of diversification. If large expenses coincide with a market decline, being forced to sell stock investments at irrationally low prices increases the likelihood of permanently reducing future growth. While lower bond returns during bull markets may bring on FOMO-style discomfort, the real value in bonds is not their return, but in having stable assets to draw on, regardless of timing, and thus greater overall financial resiliency.

We understand people may elect to dramatically change their strategy or even get out of the market entirely if a portfolio behaves in an uncomfortably volatile manner. History shows clearly that these market timing decisions, often based on fear, generally result in lower long-term returns. While the bond market may return less than the stock market over time, the inclusion of bonds reduces the risk of strategy abandonment during periods of market stress, and can ultimately improve real returns and overall resiliency in your portfolio over time.

Beyond the experiential benefits of a more stable portfolio, bonds offer another benefit – the optionality to be shifted into stocks during a period of equity market volatility.

In March, global equity prices plummeted in response to pandemic concerns, but bonds and gold largely held their value or increased in price. Those with shorter time horizons or income needs were grateful for a base of stability to draw on. Those with longer time horizons were presented the opportunity to rebalance their portfolio by selling an investment that hadn’t declined, and buying stocks at newly low prices. Having some liquidity when stock prices are falling is opportunity on a silver platter, and can be a powerful tool for patient investors in times of market distress.

The intention of periodic rebalancing is that stable reserves never get drawn down too low, nor do extended opportunities presented by low stock prices pass by unappreciated. This allows portfolios to be managed with less emotion, systematically recognizing current reality and returning the mixture of stocks and bonds to intended allocations. Trimming bonds to buy stocks can be uncomfortable, especially during a crisis like we saw in March or back in 2008. Still, a commitment to rebalancing allows you to unlock additional value from stable bond investments.

In today’s landscape of uncertainty and near-zero interest rates, we are incrementally shifting bond investments to be higher quality via larger allocations to investment grade and government-backed bonds.

With compressed interest rates and economic stress, investors are no longer being compensated appropriately for the additional risk of lower-quality bonds. Concerns remain about solvency over the upcoming year or two, particularly amongst energy, retail, and travel companies, and these “high yield bonds” may end up behaving more like stocks.

Bond holdings in our client portfolios are designed to support capital preservation – liquidity needs, stability, and optionality for future investment. Stock holdings are more oriented to capital appreciation – higher growth over time, investment in positive social and environmental impact, and include an expectation of more price volatility. The proportion of stock and bonds is determined based on each of our clients’ personal circumstances and their near-term and long-term goals.

Stability of portfolio strategy, not just price, is valuable in both financial and in personal terms. The “unexpected” in your life, or in your family and friends network, can shift what you need, and how you feel about your financial reserves. A resilient portfolio can be a resource for you, supporting your sense of flexibility rather than amplifying the legitimate fears of an unstable time.

Portfolios are not just a collection of financial data and theory. When properly designed, they support real people navigating the personal and economic vagaries of the real world. That’s their magic.

[1] The Labor Department said Thursday that 1.2 million people filed initial jobless claims in the most recent week. The number, however, is worse than it looks. When you add in the number of workers receiving Pandemic Unemployment Assistance—people such as gig workers not eligible for regular unemployment insurance—the number is more like 1.6 million. What’s more, weekly claims have remained above one million since shutdowns prompted mass layoffs in March. Barron’s

[2] Earnings Insights. John Butters, Senior Earnings Analyst. July 31, 2020  Factset.com

[3] https://www.sifma.org/wp-content/uploads/2019/09/2019-Capital-Markets-Fact-Book-SIFMA.pdf