Many stock market investors who fell into the trap of believing the market would soar forever were shocked in December, when the S&P 500 Index plunged 9.00% for the month, and declined just shy of 6.00% for the year. It reminded us of the nursery rhyme about the little girl who was very, very good, but when she was bad, she was horrid. Only it wasn’t funny. Instead, it was a sharp reminder that markets don’t rise forever, and when they turn, they can get ugly fast. Others of us had that fact burned indelibly in our mind in March 2009, during the Great Recession, when our stock portfolios were halved from their October 2007 high, and took more than three years to recover.
Our financial advisors remind us regularly that a balanced portfolio protects us—a humdrum mix of stocks and bonds that may not guarantee our portfolio will produce the highest returns, but neither will it suffer the carnage that accompanies a stock market sell-off. With the market on a roll, as it has been for the past two-plus years, it was easy to chase a soaring market that by October 3, 2018, had risen 7.00% for the year, with a double-digit return almost certain in the offing. And with the Federal Reserve on a tear to normalize interest rates, investors could be forgiven for foregoing bonds. After all, when interest rates rise, bonds decline, so why opt for a loss when attractive stock returns were ripe for the plucking? Isn’t it foolish to fight the Fed? Yes and no.
Bonds have relatively boring returns (unless they are high yield, which invest in less-than-stellar credits and carry a different kind of risk). The yield on the 10-Year U.S. Treasury Note (considered to be a risk-free investment) on October 22 was a paltry 3.20%, a return that was less than half what the stock market had delivered by then. And depending on where interest rates are during the 10-year term of the Treasury Note, investors who did purchase the Treasury might sacrifice some of that slim yield if they needed to cash it in before maturity.
But bonds have another function besides delivering yield. They stabilize a portfolio during periods of volatility. When the stock market plunged by 2500 points in December, closing out the year with a loss of 5.63%, bonds’ positive performance looked rather tantalizing by comparison.
Another reason to commit a portion of a portfolio to bonds is to prepare for a future recession. Although economic data is fairly strong, cracks are appearing: factory orders declined .06% in November (the latest reading), versus expectations of a .03% increase. Consumer confidence ebbed to 120.2 in December, compared with a consensus forecast of 126.1. (For perspective, however, Stephen Moore, chief economic analyst for The Heritage Foundation, noted in remarks at the Manhattan Institute on February 1 that it still represents a high number, as the figure has risen steadily for more than two years.) January’s Institute for Supply Management Non-Manufacturing Index declined to 56.7 from an upwardly revised 58.0 in December. Add in that the European Union and China are both showing signs of stress, making it tougher for our country to sell them our products (our trade dispute with China notwithstanding). On the plus side, employment is strong: Nonfarm payrolls climbed to 296,000 versus expectations of just 160,000, and nonfarm private payrolls were 304,000 versus the same expected figure. Most economists (who seldom reach the same conclusion) agree that employment is the singular important economic data point. People who work have money to spend, and the consumer represents more than two-thirds of our country’s GDP.
But that doesn’t mean we won’t have a recession—recessions are part of the business cycle—the question is how severe it will be (i.e., a ‘hard’ or ‘soft’ landing). Savvy investors will want to structure their portfolio to withstand a downturn, whether it’s a sluggish business cycle or a significant recession. And that includes bonds. However, investors should tread carefully when constructing a bond portfolio, given we are in a rising interest rate environment. A good strategy is a “barbell” approach—investing in both the short and long end of the yield curve. What that means in layman’s terms is having a portion in short-term duration bonds, such as three- or six-months, and a portion in longer-term issues, such as one-year. Investors can be nimble with that strategy: Three-month rates may rise, but the hit to a portfolio won’t be nearly as great as if it were invested entirely in ten-year bonds, for example. The rate on the three-month U.S. Treasury bill on February 1 was 2.35%, versus 2.69% for the ten-year Treasury bond. The 34-basis-point spread is scant reward for the risk that long rates will rise even further, causing the value of a bond portfolio to drop. Investing at the three- or six-month rate provides flexibility to reinvest at higher rates when the bond matures (assuming rates have risen). Although the Fed seems to be tuned to investors’ response to the rapidity of rising rates last year, the central bank is merely pausing, rather than stopping, its path to normalizing rates.
For the ninety years up to the middle of 2017, the stock market delivered an annual average return of 9.80%. But we know only too painfully that 2018 was a different story. Having a plan in place with an allocation to bonds makes it easier to stomach market volatility. Investors may forego higher returns in the bond portion of their portfolio, but should the market sell off or a recession strike, they will be glad they did.
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The above article is not to be considered investment advice. Please consult your tax and investment professionals before making any investment decisions.