3 Factors to Consider When Choosing Bonds for Your Portfolio
The current low interest rate environment has many investors reaching for yield by moving into longer-term, lower-quality bonds. But the fruits of that decision might not be as sweet as expected.
1. What is the risk in long-term bonds?
Reaching for yield through longer-term bonds historically has cost investors a disproportionate amount of risk-taking. We see this when looking at the tradeoff between risk and return when bond maturities increase. As we move from shorter-maturity to longer-maturity bonds, return increases slightly, but so does risk and at a much faster rate.
We look to the data for evidence on what markets have done in the past. From 1964 through 2019, one-year U.S. Treasury notes earned a compound return of 5.5% per year compared to 7.3% per year for long-term U.S. government bonds. Contrast that with the 2.4% standard deviation (a common measure of investment risk) for one-year U.S. Treasury notes and the 11.4% standard deviation for long-term U.S. government bonds. For the longer-term bonds, the risk is almost double the return.
2. What is the risk in low quality bonds?
Another way that investors reach for yield in bond markets is by investing in bonds with lower credit quality. Like we discussed above, this also involves a risk-return tradeoff that we don't feel is adequately compensated. Historically, returns for both investment-grade corporate bonds and high-yield corporate bonds have come at too great a risk, and therefore represent too costly a tradeoff, for the incremental return they provide.
“Patience is bitter, but its fruit is sweet” were words most famously spoken by the ancient Greek philosopher Aristotle. The wisdom in this adage can be applied to so many aspects of life, including bond investing.
Many investors seek to maximize each component of their portfolio performance and attain the highest level of return for each. However, the same investors who take their chances and seek higher yields when choosing bonds give up the primary benefits of fixed income in any portfolio: diversification and stability. Both investment-grade and high-yield corporate bonds historically have moved more in line with stocks than other types of bonds. This means that both kinds of corporate bonds tend to perform poorly when equity markets are also performing poorly, making them less effective as a portfolio diversifier.
Those who exercise patience can reap the rewards that short-term, high-quality bonds have to offer. It is because of these poor risk-return tradeoffs mentioned earlier that we use short-term, high-quality bonds as the cornerstone of your portfolio. We look to the evidence of decades of financial research and data in making this decision.
Evidence shows us that the cost of chasing yield in the current fixed-income markets comes at too high a price, not only in terms of risk but also in terms of reduced diversification benefits.
3. What are the alternatives for getting higher returns?
None of this prevents us from looking elsewhere in the portfolio to address your needs. If higher return is needed to fund your goals, we may look at increasing the amount of diversified equity holdings or using alternatives which have higher expected returns over fixed income over long periods of time.
If liquidity and income generation are a top priority, as they are for many who have moved out of full-time, high-achieving professional life, we can generate income by selling other assets, such as stocks, which may be more beneficial from a tax standpoint than generating income from bonds.
We just have to tolerate the bitter taste of historically low interest rates to have a successful investment experience, but that will also allow us to receive the honeyed benefits of diversification and stability along our investment horizon.
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