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Why own bonds?

Wells Fargo Investment Institute

Long bridge over water

Five issues for fixed income investors to consider and defensive ideas for today’s environment.

Longer-term interest rates are rising and some fixed-income investors are asking: Should I sell my bonds? After all, with rates relatively low, new bond purchases generally offer investors modest income opportunities at best.

We believe fixed income can continue to play an important role inside a well-diversified portfolio, even in a rising interest rate environment. Before investors make changes to how much of these investments they hold, we recommend they consider these five characteristics:

  • Performance
  • Diversification
  • Volatility
  • Yield
  • Liquidity

Performance

Although the years of strong fixed-income returns appear to be behind us, that does not suggest the opposite — significant losses — are on the horizon for disciplined investors. In fact, even in a rising-rate environment, a well‑diversified bond portfolio may provide positive returns.

However, after multiple years of high single-digit or low double-digit positive returns, bond investors may have unrealistic expectations. The current environment in which short-term rates are near zero while longer-term rates are rising is likely to drive below-average returns.

Keep in mind that bond total returns comprise two factors — price movement and yield (current income).

Why investors should consider total return

Price return (gray bar segments), is only half the fixed-income picture. Total return (blue line), which also takes yield (current income) (gold bar segments) into consideration, is a more accurate barometer. The graph shows the Bloomberg Barclays U.S. Aggregate Bond Index returns.

Bar graph depicts yield (current income) and price return, resulting in a line showing total return. Y-axis: percent return; x-axis: 1994 to 2020. In negative years for price return (1994, 1996, 1999, 2005, 2013, 2015, and 2018 are the primary examples), negative return reduces the positive effects of yield. In the years 1994, 1999, and 2013, this actually resulted in negative total returns (all less than -5%). But in positive years for price return (15 of the 27 years shown), it is added to yield, increasing total return (generally above 5%). In 1996, for example, price return was negative but the total return was positive. In 2000, looking at price alone would understate a total return of over 10%. In 2013, positive yield couldn’t compensate for negative price return.

Sources: Bloomberg Barclays U.S. Aggregate Bond Index and Wells Fargo Investment Institute. Data shown is from January 1, 1994, through December 31, 2020. The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based measure of the investment-grade, U.S.-dollar-denominated, fixed-rate taxable bond market. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

Diversification

The foundation of modern portfolio theory suggests that having a well-diversified mix of major asset classes, primarily stocks, fixed income, and cash alternatives, may help investors take advantage of different market environments and optimally balance risk and return. By drastically reducing or removing an asset class, such as fixed income, investors may take on additional risk as they become more concentrated in their remaining investments.

Volatility

For investors looking to generate higher returns in the current bond market environment, we recommend discussing current investment objectives and risk tolerance with your investment professionals. Moving investments into an asset allocation model expected to generate higher returns may be an option if increased volatility may be tolerated in a portfolio.

Yield

Investors receive different yields depending in part on the maturity of a bond purchased. This spectrum of yield across maturities is referred to as the “yield curve.” Typically, investors will receive a higher yield by buying a longer maturity. However, rather than simply selecting a longer-maturity bond to receive the highest possible yield, first consider the marginal benefit in moving out further on the yield curve.

Liquidity

Another reason to hold fixed-income positions is to help meet liquidity needs. Most bonds have a maturity at which time, if the issuer has not defaulted, principal is returned to the investor. If it is possible to anticipate when cash may be needed for a significant purchase down the road, buying bonds with a maturity near the time when money is needed can be an effective way to stay invested in the markets while maintaining some assurance that funds may be available when needed.

Our advice to bond investors

We acknowledge that fixed-income investments are likely to underperform relative to their recent and longer-term track record. For investors willing to tolerate volatility in the search for better returns, a shift out of fixed income and into a more aggressive asset allocation strategy may be appropriate. In addition, we have been leaning more heavily into stocks over bonds in most of our strategic asset allocation models but are careful not to add too much volatility for risk-averse investors.

A concentrated asset allocation strategy can be risky, so we generally recommend investors avoid them. While such a strategy can produce outsized returns, it can also lead to outsized losses — a scenario most investors are uncomfortable with.

Read the full report (PDF)