Investment-grade bonds are issued by companies, governments or municipalities that have a relatively low risk of default. Yields of these bonds have been very low for some time now. So low that you may be wondering whether they even have a place in your portfolio anymore. If you’ve been having these concerns, it’s understandable.
That said, in many cases, investment-grade bonds can still have a place in a well-diversified portfolio. Many financial experts believe that investment-grade bonds continue to offer better returns than cash while providing true diversification benefits compared to stocks. That second point is especially important for investors who have large allocations to stocks in their portfolios. If the post-COVID-19 economic recovery goes awry, owning bonds or bond funds may help offset losses caused by falling stock prices. Conversely, if economic growth continues to strengthen, investment-grade bonds may hold their value if interest rates remain low.
Are Low-Yield Bonds Worth the Risk?
When considering investment-grade bonds as a standalone investment, a big concern is that low interest rates will negatively impact investment from both risk and return perspectives by keeping yields low. The minimal expected returns may simply not be worth a bond’s potential default risk.
Despite this, many investment experts say that the expected return relative to stocks appears unchanged. Return assumptions now are no different than they have been in the past: investment-grade bonds have historically returned about 1% to 2% more than cash, while stocks have historically returned roughly 5% to 6% more than cash.
In addition to risk premiums (or expectations of excess returns above the cash rate) remaining the same, expected total returns (or the returns that include interest payments and changes in principal) have declined across all asset classes at about the same rate.
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Will Rising Rates Increase Bond Return Volatility?
Will bond returns will be more volatile than they have been historically as rates start to climb (whenever that may happen)? This can be determined by examining two variables:
- Interest-rate risk, which is a measure of potential losses when interest rates rise that is a function of both duration (or a bond’s sensitivity to changes in interest rates—in general, the higher a bond’s duration, the more its price will decline when interest rates rise) and
- The volatility of yields themselves. History suggests that, while lower interest rates indicate higher duration, yield volatility actually tends to decrease as the level of yields declines.
While a spike in yields would reduce bond prices in the near term (prices and yields have an inverse relationship), it would also improve the reinvestment outlook (as bonds mature, investors can purchase new bonds that offer a higher rate of interest) and increase expected longer-term returns. This means that a rising-rate environment may be the most beneficial of the potential outcomes over a longer-term horizon.
Reinvestment Risk from Rising Bond Prices
When interest rates fall, fixed-income returns tend to falter. As the price of a bond climbs, the fixed coupon payment (which is paid to investors as interest) shrinks. This brings the possibility of reinvestment risk, which happens when proceeds from maturing bonds are reinvested into bonds that are more expensive with lower yields.
Often, investors who find themselves in this situation wonder whether bond prices are too high to justify holding them in their portfolios, even if they do provide diversification benefits. Yet, in a world of low (or negative) short-term interest rates, it’s not unreasonable to consider most assets (stocks as well as bonds) too expensive. As a result, forward-looking expected returns would likely be lower across the board, and not just for bonds.
Historically, the performances of bonds and stocks tend to remain uncorrelated during periods of market stress. Some financial experts believe that this demonstrates that investment-grade bonds are one of the few asset classes that are genuinely diversifying to stocks.
Let’s face it—low yields aren’t sexy. And diversified portfolios are not likely to make the list of the year’s top performers. Still, investors who seek to maximize returns and minimize risks may want to continue to hold investment-grade bonds in their portfolios. Looking for a second opinion on your investments? Our advisors can help. Click here to set up a free, no-obligation meeting with one of them.