What about bonds?
There are a lot of reasons for investors to have a lot of things on their minds these days. So, if you’re feeling this way, then you are not alone.
It’s also easy to forget that a lot of what we are experiencing economically in the U.S. today is as a result of the pandemic. At the onset of the COVID-19 pandemic, policymakers initially applied some of the lessons they learned from the financial crisis. Namely, a lot of people being out of work for an extended period of time takes years to recover from. So they flooded the economy with funds to keep people and businesses afloat. The hangover from this is a really strong economy and the inflation we’ve experienced over the last couple of years.
Despite the headlines, the economy and the labor market remain really strong today, which has caused the Federal Reserve to raise interest rates to address inflation and this creates uncertainty.
The Fed is purposefully trying to slow down the economy, which has proved to be a challenge and, as a result, the prospects for either a recession or a decline in interest rates continue to get pushed out further into the future. We see rates staying higher for longer and whether it’s a soft landing or a recession is a matter of semantics. The economy needs to slow down for the Fed to do its job, but we don’t foresee a major crisis ahead.
Adding to the confusion is the fact that, seemingly overnight, you can now earn roughly 5% on cash after years of earning nothing. And bonds are now in the headlines too.
What about bonds?
My observation is that individual investors understand cash pretty well and common stocks too, but bonds? Not so much. You can move your cash around and trade stocks today with a few clicks on your phone. People steer clear of bonds because they are lot more complex and confusing than a CD or a high-yield savings account. Like stocks, bonds also trade every day on the open market, but pricing is not as transparent or efficient as the market for common stocks, and particularly so for individual investors.
Why own bonds?
The reality of long-term market returns is that stocks outperform bonds, and bonds outperform cash.
Source: Ibbotson, Standard & Poor’s, J.P. Morgan Asset Management.
Guide to the Markets – U.S. Data are as of June 30, 2023.
Stocks – offer the highest potential for returns and risk.
Bonds – offer moderate potential for returns and risk.
Cash – offers lower potential for returns and risk.
Over the last 70 years, the average annualized return of the S&P 500 was 11.1%1. So, if we know that stocks go up the most in the long run, why don’t we all just put all of our money there?
The reason is because stocks don’t go up in a straight line. There are both downs and ups along the way and the periodic volatility that is inherent in the stock market is too difficult for us emotionally-driven humans to stomach. We tend to panic when markets fall and make mistakes that prevent us from achieving the long-term returns that the stock market provides.
This is where bonds plan an important role in a portfolio. If we don’t put all of our eggs into the stock market basket, then we can smooth out the ride in our portfolio and improve the probability that we won’t panic when times get tough. This is important because you only achieve the long-term returns that the markets provide if you stay invested.
What are bonds?
Unlike a share of stock, which gives an investor a tiny ownership stake in a company, a bond is a share of a loan to a government of company. You’re not participating in the growth of a company (like a stock) by lending it money, so from bonds you can expect bonds to earn an interest rate that will be slightly higher that inflation and preserve your capital over time.
When issued, bonds pay a set interest rate each year, called the coupon rate, over a set period of time ending on a maturity date. For example, if you buy a five-year bond with a 5% coupon for $5,000, you will have nearly $6,500 by the time it matures (assuming that you reinvest the interest payments).
The coupon rate listed for each bond on your monthly brokerage statement is not exactly what you earn, however, because the “yield” that you earn depends on the cost for your bond. If you paid $5,100 for the same bond as above instead of $5,000, then your yield to maturity is 4.5% instead of 5%. If you paid $4,900, then your yield to maturity is closer to 5.5%.
Coupon vs. yield is one of the complications with bonds. As bonds trade in the secondary market every day like stocks, their prices change along with interest rates and this affects the yield you’ll earn when you purchase a bond and also what you’d get if you sold your bond. The price of a bond also moves in the opposite direction to interest rates. And so as interest rates have risen over the past year or so, the value of older bonds with lower coupons has declined. This can make it difficult to see the appeal of bonds as an asset class today.
What about high rates on cash today?
Knowing that you can earn roughly 5% in cash alternatives today (CDs, high-yield savings accounts, money-market mutual funds and short-term treasury bills), it is understandable that many investors find this appealing. You’re earning the highest interest rate you can find on the safest investments. No bond market losses or market volatility required.
But keep in mind that cash is not an investment plan. Generally speaking, in most years you actually achieve a negative return on cash after factoring in income taxes and inflation. And current yields on cash may not stay high forever because these are driven by the Federal Reserve.
With inflation having trended down significantly over the past year, most economists agree that the bulk of the Fed’s interest rate hikes are behind us. In fact, the Fed and market expectations point to lower interest rates next year and even lower rates in 2025.
At the same time, the current yield on the Bloomberg Corporate Bond Index is around 5%, close to levels last seen almost 13 years ago. The same dynamic holds for tax-free municipal bonds today too.
So while there’s not much risk perceived in parking funds in cash today, there is an opportunity risk that you’ll earn less on it in the near term future. In contrast for long term investors, you can potentially lock in 5% for maybe seven years or longer with bonds today as opposed to earning 5% for months with cash.
Trying to time “peak interest rates” is like trying to time the stock market. For most investors, by the time you recognize it’s time to get it, you’ve already missed it. The same will hold true for rates on cash and bonds.
Interest rates on cash are the highest we’ve seen in a long time, but so are the rates for intermediate term corporate bonds and municipal bonds too. Despite all of the headline noise that distracts us from our long-term investment goals, ignoring the potential money to be made in bonds right now is a mistake.
If you have questions, reach out to your ACM Wealth Advisor.
1 Source: Bloomberg, FactSet, Federal Reserve, Robert Shiller, Strategas/Ibbotson, J.P. Morgan Asset Management.
Returns shown are based on calendar year returns from 1950 to 2021. Stocks represent the S&P 500 Shiller Composite and Bonds represent Strategas/Ibbotson for perios from 1950 to 2010 and Bloomberg Aggregate thereafter. Growth of $100,000 is based on annual average returns from 1950 to 2022.
Guide to the Markets – U.S. Data are as of June 30, 2023.
The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.