With three months of the year behind us, we thought now would be a good time to reflect on what happened last year and examine how the bond market is expected to fare going forward.
From a historical perspective, 2013 can be viewed as a transitional year for bonds. Over the last thirty years, we have seen a persistent decline in interest rates. With rare exceptions, these have been great times for bond investors. The falling interest rates have lead to very good risk adjusted returns from most bond-like investments. I am proud to say our clients benefited greatly. As we have written about many times, when the Federal Reserve forced rates to their lowest levels in many generations, we knew it wouldn't last forever. Last year was the first sign we saw that proved that point. Given our experience as bond investors, we watched closely as last summer unfolded and the Federal Reserve began to hint that it would start to slowly remove (taper) its Quantitative Easing policies. Because rates were low and so many investors were expecting rates to increase at some point, the mere mention of the Fed's actions sent rates spiking up during the early summer. Due to those two months of rising rates, 2013 turned out to be the second worst calendar year on record for the Barclay's Aggregate Index, which had a negative return of 2.9%, and only the third negative total return for the index (data going back to 1976). The other negative return years were 1994 and 1999. Unfortunately, amid the 30% gain in the stock market last year, it doesn't seem that many paid attention to how bonds performed. We did. Our whole bond investing thesis has been built around how to generate income when yield is hard to come by. That thought process protected us very well last year. Diversifying our streams of cash flow proved to be the right combination. However, we have to be mindful that the interest rate environment we currently face is, and will continue to be, tricky. We don't need any more evidence than last year to prove that point.
What about this year?
We think it has been generally acknowledged that the next big movement in rates will occur when the Fed actually begins to tighten interest rates. Fortunately, most indications are for those events to play out in the future rather than now and 2015 seems to be the consensus as to when that may start.
Much like the last few years, this year's bond performance will mostly likely depend on the type of bonds you own rather than simply being in the bond market in general. Given that we are poised to have higher rates at some point, it has been advisable to minimize interest rate sensitive bonds, such as treasuries, and focus more on credit sensitive areas, such as investment grade and high yield corporate bonds. While it is still early in the year, credit sensitive areas have indeed performed better than the broader market indexes that are comprised of primarily government (interest rate sensitive) bonds. We currently believe it is prudent to employ bond portfolio strategies that give our clients exposure to many income producing sectors such as corporate bonds, high yield bonds, bank loans, municipal bonds, preferred stocks, and MLPs. The idea is that by diversifying your sources of cash flow, you will lower your overall risk to interest rate changes while still generating income. Another way to lower your interest rate risk is to manage a portfolio's duration risk and try to stay somewhat shorter in maturity.
While we do not think the Fed will surprise the market this year with rate increases, we have to be cognizant that the market itself can put upward pressure on rates. We would expect this to occur as our economy continues to show improving performance. Interest rates and economic growth measures go hand and hand. Interest rates generally move in a sequence: the economy improves, interest rates increase, inflation worries materialize, and eventually the Fed will tighten interest policies to fight inflation. This will ultimately happen, but leaves us with the question of when. The Fed policies are very data-dependent at this point. We say just stay tuned.
Why bonds?
If we are facing an environment of low yields, higher interest rates down the road, and a booming stock market, do we even want to own bonds? The simple answer is, of course you do.
Let us remember that the primary purpose of bonds in an investment portfolio is not to solely attempt to generate high returns, but rather more stable, predictable returns and to act as ballast during bad times. We own bonds because we place equal importance on diversification and risk mitigation, in addition to performance considerations. After all, bonds and stocks are completely different animals. Bonds tend to protect against the worst kind of market risk-the times when stocks suddenly, unexpectedly plunge. Prior to 2008 and just before the credit debacle began, U.S. equity markets seemed to be sailing toward another year of gains. At that time, investors were also asking, "why own bonds in an environment like this?" Yet by the end of the year, a mixed portfolio of bonds had achieved a 5.24% positive return, while stocks declined by 37%, meaning bonds outperformed stocks by more than 42 percentage points. That is a classic example of limiting risk. Moreover, in 2000, 2001 and 2002 when stocks dropped 9.11%, 11.89% and 22.10% respectively, bonds rallied to give investors returns of 11.63%, 8.43% and 10.26%.
Bottom line, investing in bonds is still one of the best ways to provide protection against the unpredictability of stock market returns. You just never know whether a 2002 or a 2008 is lurking somewhere around the corner.
