Bond Investing- Recipe for Portfolio Success
The two things most near and dear to most people are their health and wealth. As an advocate for healthy living, I continually post on social media that “health is your wealth,” as life can be challenging to take care or yourself or loved ones with one, or both out of balance. Either way, it is easy to get off track with your diet or investing strategy if you do not have positive ongoing habits, education, and a plan in place.
Years ago, the USDA “food pyramid chart” provided a representation of the optimal number of servings to be eaten each day from each of the basic six food groups for ideal nutrition and health. They illustrated the six major food groups being fruits, vegetables, grains, protein (meats), dairy and fat/ sweets. Just the same with a healthy approach to portfolio construction, it is optimal to utilize the four major investing ingredients of cash, bonds, stocks and alternatives, along with other subsets from sector selections and market caps to geographical diversification.
Jon here. Investing for your long-term goals, like cooking, is both an art and a science from the types and weightings of ingredients utilized, to the cooking methods applied to arrive at a financial result or dish where the sum of the ingredients is more powerful than each one. The goal of diversification is to reduce risk by not putting “all your eggs in one basket.” The logic is quite simple…. If you invest in things that do not move in the same direction or at the same time, then you will reduce your chances of losing all of your money at the same time when volatility hits one stock, sector or the entire market, there by smoothing out your returns over time.
Bond Ingredients
Imagine investing and building a diversified portfolio for your retirement is like planning a balanced meal. For decades, bonds have been the reliable, healthy vegetables on your plate – maybe not the most exciting, but crucial for a balanced diet in order to maintain your health. Stocks, particularly the flashy tech ones, are like your favorite dessert -sweet, exciting, and tempting to load up on, especially when they’re doing great.
For over 40 years up till the pandemic, we were in a bond bull market, which means these vegetables have been fresh, plentiful and growing. They’ve provided a steady stream of nutrients (income) and balanced out the richness of your meal (stocks). But since the top of 2021, we’ve hit a rough patch for the past 3 years – imagine a long stretch of bad harvests. The vegetables have started to look less appealing, and many people are tempted to push them off their plates entirely regardless of their age or risk appetite.
In investing terms, this rough patch is known as a bear market for bonds which has hardly occurred in modern history over the past century, except for a rough patch in the 70’s under then Fed chair Volcker, where rates shot up and bond values plummeted. Today, with post-pandemic inflation peaking, the appeal of bonds has again dropped significantly along with bond values. Investors have seen their bond returns down for the past few years while their cash accounts are offering near 5% returns, and tech stocks are skyrocketing like it’s 1999 and blowing up news and social media boards.
You are What you Eat
It’s like being at a buffet where the dessert table is overflowing with new, enticing treats. You see everyone else piling their plates high with these desserts, and it’s hard not to follow suit, even if you know that a balanced meal is healthier in the long run with less guilt or after affects. The fear of missing out (FOMO) is real. People are tempted to ditch their diversified portfolios – those balanced meals with a mix of proteins, carbs, veggies, and a bit of dessert – and just load up on the sweets. It’s extremely tempting to go all-in on tech stocks with Nvidia leading the way with record inflows, not considering industry, sector or stocks risks that could go wrong, otherwise the risk of overconcentration in one ingredient.
But here’s the thing about investing, just like with eating: it’s not just about the short-term excitement. It’s about long-term health and maintenance. A diet of only desserts will eventually lead to problems, just as a portfolio heavily skewed towards high-risk stocks can lead to significant losses if the market turns. Bonds truly work as your insurance policy over time. They do not’ work all the time, but they work most of the time.
Right now, bonds are like those vegetables on sale at the grocery store with tremendous upside. They’re not in high demand, but that makes them a good buy. When the season changes and they’re fresh again, you’ll be glad you stocked up in the short run. Lower inflation and eventual lower rates by the Fed will boost bond values, turning today’s less- appealing investments into tomorrow’s winners. Going back in time to the 2008 recession when the Fed slashed interest rates, high quality intermediate to long term bonds actually made money.
Bond Outlook and the Fed
The path of interest rates has been highly uncertain over the past few years due to inflation, economic growth, and the Fed. The 10-year U.S. Treasury yield, for instance, jumped from 3.8% at the end of last year to a high of 4.7% in April, before settling around 4.2% more recently. Higher rates have defied the expectations of investors and economists, creating a challenging environment for the bond market, since rising rates push down bond prices. However, with inflation beginning to improve, many finally expect the Fed to begin cutting rates by the end of the year. Consider the following facts as fuel to stay diversified this year and moving forward.
Recent economic reports suggest that inflation could finally be improving. After hotter-than-expected readings in the first quarter of the year, the latest Consumer Price Index data showed no change in overall prices in May for the first time in almost two years. Core CPI rose 0.2% in May, or 3.4% year-over-year, a healthy deceleration from the previous month’s 3.6% pace. Housing costs remain stubbornly high but removing them from the picture results in core inflation of only 1.9% over the past twelve months. Other data, such as the Producer Price Index, have shown signs of deflation after also coming in higher than expected in previous months.
These developments, along with new Fed guidance, have pushed rates lower in recent days, supporting bond prices. The Bloomberg U.S. Aggregate Bond Index, a measure of the overall bond market, is now flat on the year after declining as much as 4% in April while still in the red since 2021. (see chart) Investment grade and high yield bonds are now positive on the year as well. This is in sharp contrast to 2022 when bonds fell into a bear market during the historic jump in interest rates, before stabilizing and rebounding in 2023.
Improving inflation is supporting the bond market
As interest rates fall, bond prices tend to rise since the yields on existing bonds become more attractive. The yield on the investment grade bond index, for instance, is hovering around 5.3% – well above the average of 3.7% over the past 15 years. High yield and mortgage-backed securities are generating 7.9% and 5.1%, respectively.
It’s difficult to overstate the importance of these yield levels. For much of the decade after the 2008 financial crisis, many investors wondered if yields would ever improve as policy rates remained near zero – or even negative in some parts of the world. Those who rely on their portfolios for income were forced to “reach for yield” – i.e., to take on more risk to generate sufficient income such as by buying riskier bonds or replacing them with dividend-paying stocks and preferred stocks. Today, although price volatility has been elevated, retirees and investors with long time horizons can finally benefit from the most attractive yields in years.
The Fed is still expected to cut rates later this year
Inflation rates are still higher than the Fed would like, but recent improvements are exactly what policymakers want to see. Higher policy rates, after all, are meant to tighten economic activity, slow spending, and keep inflation in check. In their latest statement following the CPI report, the Fed stated that “there has been modest further progress toward the Committee’s 2 percent inflation objective.”
At his recent press conference, Fed Chair Jerome Powell also emphasized that the Fed is sensitive to the “two-sided risks” of keeping the fed funds rate higher for longer. Specifically, high policy rates may combat inflation, but they could also slow the economy in undesirable ways. Last year’s banking crisis, for instance, was due in part to the impact of rising rates on some banks that were exposed to rate-sensitive long-term bonds, commercial real estate, cryptocurrencies, and more.
The Fed’s latest projections call for one rate cut later this year, revised down from three, with the remaining two cuts pushed into next year. While this reflects the Fed’s sense of caution, it should also be taken with a grain of salt since these forecasts are often revised. As we have discussed previously, we believe the Fed does not need to cut rates this year and a recession is not yet lurking around the corner. Consumers, and the economy are continuing to move forward, albeit, slowing down a bit as inflation slowly cools off.
Bonds can still provide portfolio balance
If rates do finally ease, the historical role of bonds as portfolio diversifiers could receive a boost. Traditionally, bonds have helped to balance portfolios and help to protect investors like an air bag in a car- since they tend to move in the opposite direction of stocks. For instance, when the economy and stock market stumble or crash, interest rates tend to fall which supports bond prices.
This pattern was amplified beginning in the mid-1980s as steadily declining interest rates led to higher bond prices over the subsequent 40 years. This allowed both stocks and bonds to experience a strong bull market, with bond prices holding steady and rising even more during periods of stock market turmoil. 2022 saw a reversal of these trends with both asset classes falling due to unexpected inflation. These dynamics called into question the traditional role of bonds as portfolio stabilizers and consistent sources of yield and returns.
What does the future hold for the relationship between stocks and bonds? If inflation does improve and the Fed is able to cut rates in the coming year, then traditional patterns could finally reemerge. The chart above highlights the historical pattern for bond returns. Inflation scares and monetary tightenings such as in 1994, 1999 and 2013 can result in poor bond returns. However, once these episodes pass, investors have tended to return to bonds as important sources of yield and portfolio diversification.
Although the last two to three years have been challenging for diversified investors, the possibility of more stable rates means that bonds could be increasingly attractive. In the meantime, it’s important to stay diversified across asset classes as the Fed nears its first rate cut and the price pressures across the economy continue to subside.
The bottom line? Bonds continue to be an important part of any diversified portfolio. While the outlook remains uncertain, improving inflation and the possibility of Fed rate cuts could be positive for the bond market in the months ahead.
Just consider while it’s tempting to follow the crowd to the dessert table, remember that a balanced meal is key to long-term health. Diversification in investing, like including bonds in your portfolio, is about preparing for all seasons, not just the good ones. By sticking with a balanced approach, you will be better positioned to handle whatever the market throws your way and better help to achieve your financial goals in the long run through your 50’s, 60’s, 70’s and beyond.
For more information on our firm or to request a complementary investment and retirement check-up with Jon W. Ulin, CFP®, please call us at (561) 210-7887 or email jon.ulin@ulinwealth.com.
Note: Diversification does not ensure a profit or guarantee against loss. You cannot invest directly in an index.
Information provided on tax and estate planning is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
You cannot invest directly in an index. Past performance is no guarantee of future returns. Diversification does not ensure a profit or guarantee against loss. All examples and charts shown are hypothetical used for illustrative purposes only and do not represent any actual investment. The information given herein is taken from sources that are believed to be reliable, but it is not guaranteed by us as to accuracy or completeness. This is for informational purposes only and in no event should be construed as an offer to sell or solicitation of an offer to buy any securities or products. Please consult your tax and/or legal advisor before implementing any tax and/or legal related strategies mentioned in this publication as NewEdge Advisors, LLC does not provide tax and/or legal advice. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors.
Advisory services offered through NewEdge Advisors, LLC, a registered investment adviser.
