At ML&R Wealth Management, we counsel our clients on the importance of maintaining discipline when it comes to investing. While we fully understand that a normal reaction to market volatility can cause clients to become emotional and question their investment plan, we advise against making changes to an existing long-term plan based on recent market performance or news cycles. Until recently, most of the attention in the investment world was given to stocks, with bonds receiving far less. As bonds are generally less volatile than stocks, and have a lower expected rate of return, it makes sense that bonds have remained more in the background. That may be changing.
Since the Global Financial Crisis of 2008-09, interest rates have been kept historically low to spur more economic activity, and bonds have been performing accordingly. The Bloomberg U.S. Aggregate Bond Index has posted an annual average return of 2.17% over the last 10 years, lower than the longer-term average. Since March of 2009, the S&P 500 Index has had an annual average return of 17%, so most investors have not complained too much about the lackluster performance of bonds. But now that bond values have been declining steadily, with the Bloomberg U.S. Aggregate Bond Index returning -4.15% over the last 12 months, bonds have been receiving more attention. For more context, let’s take a closer look at the characteristics of bonds, stocks vs. bonds, why they have been declining in value, and the role they play in a balanced portfolio.
There are several types of investment risks associated with bonds, such as credit/default and liquidity, but the two most relevant risks in today’s environment are driven by inflation and interest rates. Inflation has risen 8.5% over the last year, most likely due to a combination of widespread supply and demand imbalances, supply chain disruptions, and pandemic-related government relief spending. We are seeing the highest increase in inflation for decades. If you are holding a $1,000 bond that you bought several years ago, yielding 3%, which will mature after this rise in inflation, you will get your $1,000 principal investment back, but your purchasing power has been eroded significantly. This is inflation risk.
High inflation can be a sign of an overheating economy. In order to cool it down, reduce consumer demand and bring the economy back into balance, one tool the Federal Reserve relies on is raising interest rates. Last month, this is exactly what the Fed voted to do, by raising the Federal Funds Rate +0.25%, with more expected increases planned for this year. This rate increase flows down to financial institutions and affects consumer lending rates, but also bond values and yields, or income rate.
Bond values and interest rates have an inverse relationship. When interest rates go up, existing bond values go down, and vice-versa. If I am a bond buyer, and I have $1,000 to spend, I would rather buy a new bond with a higher yield, than an existing bond with a lower one. If I am a bond seller, I would have to drop the price of my older bond to make it more appealing to a buyer. This is why we invest in shorter term bonds (and bond index funds) for our clients. When the bonds mature sooner, we can go out and buy new bonds that are paying higher interest rates.
There is an old saying that “stocks are for building wealth, and bonds are for preserving wealth.” While this may be an oversimplification, it is largely true. So which is better for you at this stage in your life: stocks vs. bonds? When people are younger and in their wealth accumulation phase of life, it makes sense to invest more in stocks, since stocks have a higher expected rate of return, and young people have more time for their portfolios to recover from market volatility and corrections. As people get closer to retirement age, they focus more on preserving their wealth by investing in less volatile bonds. Typically, their retirement assets will be less likely to go down in value as they slowly withdraw the money. For this reason, it can be especially alarming for retirees to see their normally reliable bonds go down in value, and we have not seen this in the bond market for the last 15 years or so. While this does lead to the short-term pain we are feeling now, it is actually good for bond holders in the long term.
Since 2008, the historically low interest rate environment has offered investors no reliable, safe place to park cash and get a decent yield. But once inflation is tamed, and rates stabilize, the likely return to a historically average rate of 4-5% is a positive, as savers and retirees will be rewarded more for holding fixed income in their portfolios. And while younger investors may not want to have as much bond exposure, having some remains a key component of a well-balanced portfolio and has historically provided a cushion against stock market volatility.So, tempting as it can be, we should not overreact to short term market conditions, or make rash portfolio changes. We will be better served reminding ourselves that we have a long-term investment plan that accounts for these kinds of volatile periods. And if you do not have a financial plan, please reach out to our Austin team of financial advisors and let’s start a conversation about how we can support you in creating one that is customized to your needs and risk tolerance.
Please contact us if you have questions about stocks vs bonds or any other topic.