Strong year-to-date returns moved the S&P 500 Index of U.S. stocks back to all-time highs in October.
When stocks advance swiftly, it naturally draws attention. By comparison, bonds are often considered boring. But as the broad U.S. stock market has gained more than 20 percent this year, the U.S. aggregate bond market is within range of its best calendar-year performance since 2002. Bond market returns year-to-date in the territory of 8 percent are more than double the average annual return of the past 16 years.
When interest rates are declining, investors prefer to hold previously issued bonds at higher interest rates than new issues at lower rates. This drives up the price of existing bonds as supply-and-demand factors influence the marketplace.
Bonds are not perpetual, however. They expire. When an existing bond matures — a direct investor or professional fund manager must replace it. This could mean buying a newly issued bond with a lower interest rate or paying a premium for an existing bond that someone else is willing to sell.
As long as interest rates are declining, or low and flat, bond performance could continue to stand out in the short term. The Federal Reserve cut rates for a third time this year on Oct. 30. This is one influence that has shifted bond performance into higher gear this year. Surprisingly strong returns overshadow developing characteristics of the bond market that do not project enviable returns longer term.
We have entered a period where bond holdings should be evaluated beyond the at-a-glance thankfulness of recent returns. Bonds are less volatile than stocks, but it is still the case that investors should take only as much risk as they can reasonably be expected to be compensated for with any kind of investment.
Two ways that investors regularly take more risk while investing in bonds are to buy bonds from issuers of lower credit quality, therefore paying higher interest to attract investors, or to buy longer-term bonds.
Credit risk is typically a factor for investors purchasing corporate bonds rather than government bonds. Investors can invest in the bonds of highly-rated individual companies or they can move down the corporate credit ladder by buying bonds of less credit-worthy companies. At a certain point, these bonds carry the “junk” moniker — or as investment marketers prefer, “high-yield” bonds. A key concern, frequently expressed by bond market analysts lately, is that there has been an overabundant supply of bonds that are on the cusp of this junk status.
Even a moderate economic disruption could cause a wave of defaults where companies with less financial strength fail to pay back bondholders. PIMCO is widely viewed as the most prominent bond fund manager in the United States and has expressed significant concern about this.
Default is the most evident risk, but another form of bond risk is simply paying too high a price for bonds. The higher the price paid, the lower the expected return. If you pay a high price and you do it for a lower-credit-quality bond to reach for higher income, you’ve multiplied the probability of an unpleasant outcome.
Some investors, instead of lessening credit quality, choose to extend the length of the bonds they own. Instead of owning bonds that mature in 1-3 years (short term) or 3-10 years (intermediate term), they buy long-term bonds, some issued many years ago with higher income payments. This has been rewarded with exceptional returns recently. But again, this may be a territory where the likelihood of being adequately compensated for the amount of risk taken is lessening.
Interest rates could continue to move down, maintaining the boost for returns of existing bonds. The futures markets, where traders exchange contracts that represent bets on future prices of various investments, suggest that U.S. interest rates will trend down into 2021.
Given the changing landscape, it’s time to re-evaluate how your bond investments are positioned. If you want to reduce risk in your portfolio (possibly sacrificing some return) you could consider higher credit quality “investment grade” bonds. You could also consider bond funds that invest in not just government or corporate bonds but also mortgage-backed securities that could add diversification, to lower risk, and improve return prospects.
In addition to lightening low-quality bonds, reduce exposure to international bonds —particularly those from the European Union and Japan where interest rates are negative. Emerging markets bonds might still present attractive return prospects among foreign bonds but realize that many emerging markets bonds are equivalent to high-yield/junk bonds in the U.S., with more potential reward but higher risk.
Risk in bond investing comes at a different scale than stocks, but it shouldn’t be ignored when you evaluate how a strong year of performance has changed the risk/return profile of your portfolio.