By Jonathan Lapine, CPA, CFP®
For investors who utilize diversified portfolios, particularly those approaching or in retirement, Bonds can often represent a significant portion of one’s overall portfolio. With Federal Reserve Chairman Jerome Powell recently confirming the Fed’s desire to keep interest rates low for the foreseeable future, some have begun to question the efficacy of their bonds going forward. If interest rates are barely over 0%, how exactly can one expect meaningful portfolio growth when half or more of their portfolio consists of these low interest-bearing instruments, and is it time to find a replacement for bonds?
Frankly, this is a question we’ve been getting for some time now as interest rates have been trending on a steady decline since the Fed Funds Rate surpassed 22% (wow!) in 1981. While in many areas of Fed policy we do have some uncharted waters to navigate, we aren’t actually in new territory on this one. The average Fed Funds Rate yield since 2001 has been a stingy 1.5%, so we do have the benefit of looking back at how bonds have weathered previous low interest rate environments, and the answer may surprise you. Most recently, you may not recall that the Federal Reserve took a similar approach from 2009 – 2015 with the Fed Funds Rate (1). During that period, the fed funds rate average was 0.13%. The broad bond index now known as the Aggregate Bond Index (the Agg), and Municipal Bonds actually averaged an annual return of +4.23% and +6.20% during that same period, respectively (2). So, at least in recent history, the Fed’s interest rates alone did not prevent bond owners from receiving some fixed income return. While Chairman Powell’s suggestion that the Fed may allow for inflation to surpass targets without moving interest rates, spurring inflation has been an unfulfilled desire of the Fed for the better part of the last decade and it remains to be seen how robust inflation will be in periods of economic distress.
The other dilemma is, if not Bonds, then what? While hedge funds have been exploring complex and expensive alternative investments for some time as a possible bond substitute, their track record has been inconsistent at best. As we saw again in March of this year, Bonds still excel at providing sturdiness during periods of stock market volatility due to their low correlation to equities. Even what some might consider “safer” stocks saw 30%+ declines this past March, and attempting to replace bonds with less volatile, dividend producing stocks can end up overconcentrating your portfolio to certain sectors like Utilities, Financials and Energy, and carry similar sensitivity to interest rates. For those actively drawing retirement income from their investments, needing to generate income off a portfolio experiencing big, sustained dips could permanently alter one’s retirement picture. As an example: If you have $100,000 and experience a 20% dip, withdraw $5,000, then experience a 20% recovery, your may have averaged a 0% return but you’re only left with $90,000. The same example with only a 5% decline leaves you with $94,500.
In summary, while it may be unlikely that bonds churn out double-digit total returns in this environment, we still feel at this time they serve an important purpose in one’s diversified portfolio.
Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the CFP® certification mark, the CERTIFIED FINANCIAL PLANNER™ certification mark, and the CFP® certification mark (with plaque design) logo in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.
The information provided does not constitute an offer or a solicitation of an offer to buy any securities, products or services mentioned. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Consult your financial professional before making any investment decision. Indices are unmanaged and do not incur fees, one cannot directly invest in an index. Past performance does not guarantee future results. Diversification does not guarantee investment returns and does not eliminate the risk of loss.
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