I’ve written about bonds before and what they represent. Essentially a bond is just an “I owe you” with a promise to return the face value back to you at a particular date. The benefit of holding a bond is that you get to collect interest payments based on the fixed percentage that is set on the face value.
Over the last decade bond prices had been rising because interest rates from all governments were being slashed to near 0%. This meant bonds that perhaps paid 2% to 4% interest had their prices doubled and their yields halved to 1% to 2%. That’s because interest paid is inversely proportional to the price of the bond. The higher the price of the bond the lower the yield.
At the end of 2016, the Federal Reserve in the United States signaled to the world that it was ready to raise interest rates off of the rock bottom rates. The result?
Over the last 6 months of the year, the yield on a US 10-year treasury note started to rise. This corresponded with falling bond prices. This means had you invested in bonds for 2016, you might have lost capital even though interest payments were higher per share.
One of the popular, lower cost bond ETFs by Vanguard (VAB) which holds a variety of long and short term bonds reflects this lost of capital near the end of 2016:
Near the tail end of 2016, bond prices had started to drop. It won’t be uncommon to see this trend continue into 2017 as the Federal Reserve continues to increase interest rates south of the border. Despite the fact that the Bank of Canada is not following suit with the US in raising short term rates, the markets on the other hand, is starting to reflect this restriction of money supply.
The truth about interest rates is that there is very little the government can do about it. It is still set by the free market. If you, as an investor, is given the chance to collect 4% versus 2% in interest payments, where would you put your money? That’s why to remain competitive, bond prices in general will move in tandem to the forces in the marketplace.
Should You Avoid Bonds Altogether?
The use and purchase of bonds in a balanced portfolio is still very important. It might be the only asset class available that has a negative correlation to the stock market. That’s because as stock markets crashed, investors inevitably run back to bonds as a safe haven.
Historically, bonds have been used to dampen large swings in an investment portfolio. Rather than riding the roller coaster of the stock market where you might get extreme peaks and valleys, bonds will help smooth out that curve. So rather than falling from Mount Everest you might only glide down the Adirondacks instead.
If you already have bonds in your portfolio don’t rush to sell them. Remember they are there to act as a brake of some sorts. When your stocks are driving too fast, like 2016, bonds will pull you back a little. Ultimately, when a correction happens, bonds will also help cushion the fall. It’s your airbag. You need it for safety.
If your bond allocation is smaller than what you want it to be, you can be more defensive with your bond purchases by buying bonds with a shorter duration to maturity. Short term bonds usually offer a lower yield, but they are affected less by interest rate changes.
Let’s take a look at the reaction of a short term bond ETF by Vanguard (VSB):
Though rising interest rates had an impact on the price of short term bonds, it was less dramatic when compared to what the long term bond fund had.
The one caveat of short term bonds is that they don’t have the same negative correlation to stocks. Essentially, what shorter term bonds are doing is acting as a glorified GIC, since the yield is slightly higher than what a bank savings account is giving you.
You might wonder why you should even hold bonds if all signs point to rising interest rates. It’s simple. You still want to stay diversified. There is a lot that can still happen in 2017. No one knows what to expect from President-elect Trump. He has little political experience and there is potential for a shock to happen in the stock market if the policies that he enacts don’t fare well. That’s why you still want the presence of bonds. They are tried, tested and true.