Long and difficult-to-read books and articles abound on asset allocation strategy and the role that fixed income plays in a diversified portfolio. This note aspires to be neither long, nor difficult! Rather, we want to take a moment to remind ourselves and our readers of the important role that bonds play in a portfolio, even when the world is telling us they just don’t make sense.
First, what is the purpose of holding bonds in a portfolio?
The main reason that we broadly include bonds in portfolios is that they serve as a dial. A properly constructed bond allocation helps mitigate portfolio risk in a diversified portfolio and allows an investor to target an appropriate balance of growth opportunity and capital preservation with greater confidence. To the extent that we desire or need more stability in a portfolio, we dial up the fixed income allocation. To the extent that we want or need more growth, we reduce the bond allocation in favor of assets with more growth potential.
“OK,” we can hear you saying, “if this is the case – that bonds are in my portfolio to increase stability – why in the world do I want to own bonds now, when we KNOW that interest rates are going up? Does that not ensure that the bond position of my portfolio will be going down in value, thus working against the stability objective? Oh, and haven’t I heard that you should never own bonds in an inflationary environment? What gives?!?”
Great questions, and herein lies the beauty of a well-constructed bond allocation.
For simplicity we are narrowing the scope of this note to treasury bills (short term maturities), notes (medium term) and bonds (long term). It is tempting to believe that the yield of a 10-year treasury bond can be derived mathematically as a function of shorter-term yields on treasury bills. After all we are talking about US government securities, which are all but guaranteed and carry virtually no default/credit risk. In practice, though, we see that financial markets drive changes in the shape of the treasury curve, which is not merely a straight line that moves up with increases in the Fed Rate. Why? Quite simply, there are many factors that influence the supply of and demand for various treasury maturities across time.
By way of example: At a time when the short-end of the treasury curve is primarily being driven by expectations for increases in the Federal Funds Rate (pressuring yields up and price down), it is quite conceivable that longer dated treasuries are being priced based on lower economic growth /inflation expectations, both of which are influenced by a more restrictive monetary policy and place downward pressure on yields leading to increases in price.
Geopolitical and macroeconomic flights to quality further lead to adjustments in the linearity of the treasury curve, and this diversity in the drivers of bond pricing is GOOD news for investors! Oftentimes these episodes in the bond markets are contiguous with increases in stock market volatility, making bonds allocations an important part of the portfolio for stability-based investors… even in rising-rate, inflationary environments.
The bottom line is this: The prices of fixed income securities are driven by different factors than the prices of equities, which allows them to dance nicely with equities through time. Their full beauty, though, shines through in periods where we are inclined to ask, “Bonds, are you serious?” It is during these times that long-term investors are served well by the breakdowns in linearity – and resultant reduction in portfolio volatility – that we see when different parts of the portfolio are being driven by different pricing factors.
