You still need bonds

  By Guest Blogger Ryan Lewenza

We routinely meet with clients to discuss their portfolio, review their financial plan, provide our current outlook and to see if anything material has changed with them. In a recent review with a client, I recommended reducing risk in the portfolio by rebalancing the asset mix back to our long-term 60/40 asset allocation, trim higher risk US small-cap securities, and add to a low-risk bond position. The client asked why we were trimming securities that were doing so well and were profitable for a position that hasn’t done much over the last while. In response, I went through the merits of rebalancing, the benefits of a balanced portfolio, and discussed the importance of balancing risk with returns. That call got me thinking about this topic, so today I’m going discuss the need for bonds in a portfolio and how best to position the bond allocation in a rising interest rate environment.

First and foremost, the main reason we recommend holdings bonds is that it helps to reduce portfolio volatility, smooth out the ride, and through this, help keep our emotions in check so that we stick to the long-term plan.

One common way to measure volatility is using standard deviation, which measures the variability of returns around the long-term average – the higher the number the higher the volatility. Over the last 10 years, the TSX has exhibited price volatility of 14.1%, meaning that TSX returns have been 14.1% above/below the long-term average return over the last 10 years. Volatility (standard deviation) has been 11.4% for the S&P 500 over this period. And for the average Canadian balanced portfolio, the standard deviation has been much lower at 8.3%. So, we prefer balanced portfolios to an all-equity portfolio since the ride is much smoother and with more consistent yearly returns.

Volatility of Different Investments

Source: Canadian Investment Fund Standards, Turner Investments

The other important reason we like balanced portfolios is because bonds often zig when equities zag. This dynamic is why a balanced portfolio exhibits lower volatility.

In good economic times corporate profits rise and investors feel more optimistic about the outlook that they are willing to pay higher multiples (e.g., P/Es) for stocks. This combination of rising corporate profits and valuations pushes stock prices higher.

Central banks in turn tighten monetary policy by hiking interest rates. This helps to push bond prices lower (prices move inversely with yields). So stocks go up and bond prices go down, generally, in a strong economy.

Conversely, in a weak economy stocks typically decline and central banks lower interest rates to help spur growth which leads to higher bond prices. Again, bonds zig when equities zag. This is perfectly captured in the chart below which shows the relative performance of Canadian bonds and the TSX. Note how bonds will outperform stocks over certain periods (in green) and underperform stocks in other periods (in red). This chart captures the essence of why a solidly constructed and well-managed balanced portfolio works!

Bonds/Equities Out/Underperform Over Time

Source: Morningstar, Turner Investments

Finally, how should investors structure their bond holdings in this rising interest rate environment?

First is to focus on lower duration bonds. Duration measures a bond’s price sensitivity to changing interest rates. If a bond (or in our case a bond ETF) has a duration of 8, it means the bond will decline approximately 8% for every 1% increase in interest rates, or rise 8% for every 1% decrease in rates; the higher the duration the higher the price sensitivity to rising rates.

Given our view that rates are going to continue to slowly rise, we are positioning our balanced portfolio with lower duration bond ETFs so as to minimize the impact of rising rates. Later when interest rates are higher we’ll look to reverse this call and shift into higher duration/yielding bond ETFs.

The other key strategy for bonds in a rising rate environment is to overweight corporate bonds versus government bonds.

With the Fed and BoC now hiking rates, government bond yields are moving up and prices lower. This of course weighs on all bonds but corporate bonds tend to outperform when rates rise. This happens for a few reasons. First corporate bonds offer higher coupons (yields), which help lower the duration relative to lower yielding government bonds. Second, because investors are feeling more optimistic about the economy and financial markets they are more willing to buy corporate bonds, which pushes up their prices relative to government bonds resulting in compression of the yield spread over government bonds.

Below is a chart comparing US investment grade corporate bond yields to comparable US government bond yields. Currently with US corporate bonds yielding 4.25% and US government bonds yielding 2.35%, this results in a “spread” of 190 bps. As the economy picks up this spread compresses which results in corporate bonds outperforming government bonds. We believe this spread could compress a bit further resulting in additional outperformance from corporate bonds. We’ll look to reverse this trade as we start to believe the economy is rolling over.

US Credit Spreads

Source: Bloomberg, Turner Investments

We get it. In a raging bull market like we’ve been in for some years, bonds can be disappointing and cause us to deviate away from a balanced portfolio, focusing more on equities. But as we’ve shown, the benefits of including bonds in a portfolio are to reduce volatility and provide more consistent returns. And we’re not always going to be in a bull market so you’ll need protection against this inevitability. I feel confident that our client will call me up to thank me for our recent portfolio adjustments, likely when that dreaded bear market rears its ugly head. How are you positioned for this eventuality?

Ryan Lewenza, CFA,CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.