At some point, the Federal Reserve will begin the measured process of raising interest rates. No one denies it. The unprecedented condition of near zero rates must be manipulated back to levels deemed ‘normal’ and soon as the economy continues to improve. Another undeniable fact is that as interest rates rise, bond prices will fall. So doesn’t it make sense to get out of bonds? Everyone else seems to be doing so.
Let’s address what most others are doing first. It seems quite logical to sell an asset in advance of an almost certain decline in value. It also seems right if you were holding bonds as a good investment for safe income. When it’s no longer safe, then it’s time to dump them, right?
You will get no argument on either front from the bulk of the commission-based and transaction-driven financial services industry. Brokers don’t get paid until their clients buy or sell. In fact the general advice from brokers, market pundits, and media hosts is to dump all US bonds before the Fed raises rates and replace them with foreign bond funds or dividend-paying stock funds. If everybody is saying it . . . ?
The beauty of markets is that in every transaction there’s a seller and a buyer. Given that most folks think selling bonds in the face of interest rate increases is the wise course, then those holding them or buying them must be wrong, perhaps even fool hearty. But to adequately address the question of wise or fool hearty we need a broader understanding of the purpose of bonds, specifically Treasurys.
Bonds in general and Treasurys in particular have a unique quality that most stocks do not have. They attract investors’ money when uncertainty rises. When added to investment portfolios Treasurys provide a shock-absorbing effect, offsetting the declines in stocks with commensurate increases in their value.
The chart below shows how the 7-10 Year Treasury Index has performed relative to the Total US Stock Market since the “taper tantrum” on May 22, 2013 when Fed Chair Ben Bernanke announced the onset of moves to increase interest rates. The circles highlight some of the more significant jumps in Treasurys’ value since that time. Notice the corresponding dips in the blue line representing the Total US Stock Market Index.
Including Treasurys in a portfolio has the effect of leveling the ride experienced by investors during turbulent times, even when everyone in the world knows the Fed is going to be raising interest rates. This smoothing effect is much more important than you might realize.
In the first place a portfolio of all stocks is volatile. The worst volatility in this generation was experienced between October 15, 2007 and March 2, 2009. The Total US Market (S&P 500 as well) was down -53%. Our Balanced Portfolio which holds 37% US Treasurys was down -28%, just over half as much as an all-stock portfolio. The difference is explained by the 7-10 Year Treasury component of that portfolio which rose 20% during the same period.
When investors remove bonds from their portfolio they open themselves up to significant areas of risk. The first is the possibility of being driven out of the tremendous wealth-building power of the capital markets when a decline comes beyond their ability to stick. Who wasn’t rattled by the 53% decline of 2009? But none of our Balanced Portfolio clients (while still down 28%) jumped ship.
The second risk is more subtle, but equally if not more damaging to wealth. The more volatile a portfolio is engineered to be, the less confident its owners can be that it will accomplish all it should – which is essentially to provide certain cash flows over the lives (and possibly generations) of its owners. Anyone spending money from their portfolio during the financial crisis intimately understands how ‘expensive’ those draws felt while their nest eggs were down 35%, 45% or 53%. Quite simply, the odds of exhausting your wealth go up as your portfolio becomes more volatile.
Treasurys, better than any other asset class, reduce the volatility in portfolios caused by stocks. We encourage our clients to think of them as insurance against both uncertainty and the storms of volatility. Insurance is not free, but the Treasury, with it’s current yield of 2% steadily offsetting any losses caused by rising interest rates, are a pretty good bargain. We own an index of 7-10-year maturities of Treasurys. They are not allowed to mature as new ones are cycled in to replace the maturities falling under 7 years, so we are not guaranteed a repayment of principal at maturity to offset any market losses. But a mitigating factor is that during periods of rising interest rates, new bonds added to the index generate higher yields which serve to further offset any market losses suffered.
Even if you are certain that Treasurys will be under selling pressure as interest rates rise, you can never be certain of when the next major shock to markets in general and stocks in particular will occur. That’s a bad time to have no insurance against the volatility that will surely wreak havoc on your portfolio and likely your lifestyle.
When one looks at investing as an integral component of a much larger comprehensive life plan, taking into account as many variables, priorities, and goals as are important, the need for and the right-sizing of US Treasurys becomes imminently apparent.