August 29, 2022

Traditionally, high quality fixed income has played three important roles in an investor’s asset allocation: principal preservation, a steady source of safe income, and risk reduction through diversification. After massive pandemic-induced monetary and fiscal stimulus, the appeal of high quality bonds had diminished some. Its ability to preserve principal was 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, the key attributes of high quality bonds have returned. So, whether your asset allocation seeks principal preservation, steady income, or diversification, high quality bonds can once again fulfill their traditional roles in your portfolio.

PRINCIPAL PRESERVATION

Bonds mature at par. Assuming you can hold them until maturity, and the underlying companies do not default on payment, daily fluctuation in market value will only show up “on paper.” Periodically, you will receive income in the form of coupon payments, and at the bonds’ maturity, you will receive your initial principal back. It’s these characteristics that give 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 3.00%

- Duration 4.00%

- Interest rate rises 1.00%

- Price falls $40,000

Cash Flows:

- $30,000 Annual Coupon Income

- $1,000,000 Maturity Payment

Coupon Income web

STEADY SOURCE OF SAFE 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. Add the surging inflation narrative, and bonds were not only producing very little nominal income, they were experiencing significantly negative real yields.

More recently, with the Federal Reserve raising interest rates at an accelerated pace and credit spreads widening to near their long-term average levels, investors are rewarded for taking reasonable amounts of interest rate and credit risk. The result, investors can once again access the steady source of safe income provided by high quality bonds.

Yield to worst

RISK REDUCTION THROUGH DIVERSIFICATION

To act as a hedge against underperformance in riskier, non-correlated assets, high quality bond portfolios should be structured to produce capital gains, as well as, steady income during times of market distress. We’ve all heard the phrase, bond prices move in the opposite direction as their yield. Well, if the yield on a bond portfolio is so low that it realistically cannot go lower, then the portfolio has very little ability to appreciate in value.

To illustrate the impact of both yield and interest rate risk when rates rise or fall, consider two portfolios: one with a beginning yield-to-maturities of 0.75%, the other 3.25% YTM. Both have the same interest rate risk with a duration of 4.00%.

Returns in Rising and Falling Rate Scenarios

In this example, with spreads tight and the Federal Reserve having forced interest rates to unnaturally low levels (0.75%), bond portfolios offer limited upside but are still exposed to meaningful negative returns in a rising rate environment. As yield rises (x-asxis), the low interest rates does not offer much of a buffer to the drop in price.

Portfolio return 2

With yields at a more normal level (3.25%), bonds offer a meaningful upside and should act as a hedge against equity underperformance. Conversely, should rates continue to rise, the higher yields currently available act as a counter to the negative price movements, reducing downside risk.

“Madison” and/or “Madison Investments” is the unifying tradename of Madison Investment Holdings, Inc., Madison Asset Management, LLC (“MAM”), and Madison Investment Advisors, LLC (“MIA”), which also includes the Madison Scottsdale office. MAM and MIA are registered as investment advisers with the U.S. Securities and Exchange Commission. Madison Funds are distributed by MFD Distributor, LLC. MFD Distributor, LLC is registered with the U.S. Securities and Exchange Commission as a broker-dealer and is a member firm of the Financial Industry Regulatory Authority. The home office for each firm listed above is 550 Science Drive, Madison, WI 53711. Madison’s toll-free number is 800-767-0300.

Any performance data shown represents past performance. Past performance is no guarantee of future results.

Non-deposit investment products are not federally insured, involve investment risk, may lose value and are not obligations of, or guaranteed by, any financial institution. Investment returns and principal value will fluctuate.

This website is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.

“Madison” and/or “Madison Investments” is the unifying tradename of Madison Investment Holdings, Inc., Madison Asset Management, LLC (“MAM”), and Madison Investment Advisors, LLC (“MIA”), which also includes the Madison Scottsdale office. MAM and MIA are registered as investment advisers with the U.S. Securities and Exchange Commission. Madison Funds are distributed by MFD Distributor, LLC. MFD Distributor, LLC is registered with the U.S. Securities and Exchange Commission as a broker-dealer and is a member firm of the Financial Industry Regulatory Authority. The home office for each firm listed above is 550 Science Drive, Madison, WI 53711. Madison’s toll-free number is 800-767-0300.

Any performance data shown represents past performance. Past performance is no guarantee of future results.

Non-deposit investment products are not federally insured, involve investment risk, may lose value and are not obligations of, or guaranteed by, any financial institution. Investment returns and principal value will fluctuate.

This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.

Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only, and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance.

The Bloomberg Intermediate Govt/Credit Bond Unmanaged index that tracks the performance of intermediate term US government and corporate bonds.

Bond Spread is the difference between yields on differing debt instruments of varying maturities, credit ratings, and risk, calculated by deducting the yield of one instrument from another.

Bonds are subject to certain risks including interest-rate risk, credit risk and inflation risk. As interest rates rise, the prices of bonds fall. Long-term bonds are more exposed to interest-rate risk than short-term bonds.

Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates. Duration measures how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s total cash flows.

Principal preservation statements relate to investment objectives and assume all bonds are held to maturity with no defaults. Market value between purchase and maturity may vary.

Yield to Worst (YTW): the lowest potential yield that can be received on a bond without the issuer actually defaulting. The yield to worst is calculated by making worstcase scenario assumptions on the issue by calculating the returns that would be received if provisions, including prepayment, call or sinking fund, are used by the issuer.

Yield to Maturity (YTM) measures the annual return an investor would receive if they held a particular bond until maturity as of the end of a report period In order to make comparisons between instruments with different payment frequencies, a standard yield calculation basis is assumed This yield is calculated assuming semiannual compounding.