Why Bonds Now?

Bond Concepts by Madison Investments

Traditionally, fixed income has played three important roles in asset allocation: principal preservation, steady income, and risk reduction. After pandemic-induced monetary and fiscal stimulus, the appeal of bonds had diminished some. The ability to preserve principal remained intact, but low yields meant that income was not keeping up with inflation, and the prospect of a rising rate environment meant elevated interest rate risk with limited downside protection.

Today, these key attributes of bonds have returned, and investors can again expect their fixed income allocation to fulfill its traditional role in a portfolio.

Principal Preservation

Bonds mature at par. And, assuming the bond is held until maturity and the underlying company or issuer does not default on payment, daily fluctuations in market value will only show up “on paper.” The bondholder receives income in the form of coupon payments, and at the bond’s maturity, the bondholder will receive the initial principal back. These characteristics give bonds – particularly high-quality bonds – the ability to preserve principal in difficult markets.

Scenario:

5 Year Maturity
$1,000,000 Face Value
Purchase at Par ($100)
Coupon 4.50%
Duration 4.00
Interest rate rises 1.00%
Price falls $40,000

Cash Flows:

$45,000 Annual Coupon Income
$1,000,000 Maturity Payment

Steady Source of Income

For much of the last 15 years, low rates from the Federal Reserve had starved the markets of income. In July 2020, the ten-year Treasury yield fell below 0.60% and remained below 1.00% for much of 2020 and into 2021. At the same time, corporate bond spreads relative to Treasuries tightened to historically low levels, giving investors little reward for taking on interest rate or credit risk. Then came the surge in inflation, and suddenly, bonds were not only producing very little nominal income, but they were also facing significantly negative real yields.

With the Federal Reserve raising interest rates at an accelerated pace starting in 2022, investors are again rewarded for taking on interest rate risk. For the first time in over a decade, high-quality bonds, in particular, offer a steady source of safe income.

Risk Reduction Through Diversification

When a bond portfolio is structured to produce both income and capital gains, it can act as a hedge against underperformance in riskier parts of an asset allocation. To demonstrate the importance of income in this equation, consider the impact of rising and falling interest rates on a bond’s price return.

Bond prices move in the opposite direction as their yield. With yields so low, as they were in 2020-2021, a bond portfolio would have very little capacity to appreciate in value while still exposed to meaningful downside risk should rates eventually rise.

Consider two portfolios: one with a beginning yield-to-maturity of 0.75%; the other 4.50%. Both portfolios have the same interest rate risk, with a duration of 4.00.

Returns in Rising and Falling Rate Scenarios

In the first example (0.75%), the portfolio offers limited upside while still being exposed to meaningful negative returns in a rising rate environment. As the yield rises (x-axis), the low starting interest rate will not offer much of a buffer to the drop in price.

With yields at a more normal level (4.50%), the second portfolio offers meaningful upside potential and should act as a hedge against equity underperformance. Should rates continue to rise, the higher starting yield will serve as a counter to negative price movements, reducing downside risk.