UBS: How I learned to stop worrying and love the bonds

Last year’s market performance in Twitter form?

Equity returns strong, bond returns flat. Despite institutional investors appearing to be engaged in a record shift from US stocks into bonds, the weak performance of the latter has many private investors asking whetherbonds are still worth owning.

We think they continue to play a vital portfolio role, even when rates are rising, for the following reasons:

1. Income and stability

A bond owner is entitled to periodic interest payments and principal repayment at maturity; the predictability of the amount and the timing of the payments are fundamental to low bond market volatility.

2. Portfolio diversification

Stocks and bonds are uncorrelated over the long run, so the two markets’ returns move independently. Yet bonds tend to benefit from a “flight to quality” during equity market declines. Holding bonds can help reduce portfolio drawdown intensity and duration when stocks are falling, giving investors the psychological and financial wherewithal both to hold the course and to take advantage of opportunities. In fact, despite the longterm outperformance of stocks, the highest-returning portfolio of a given time frame shorter than 20 years typically includes some bonds (see figure).

3. Liability matching

Finally, bonds provide a clear mechanism for meeting spending objectives with assets. This is the most fundamental rationale for holding them. It also explains why pension funds buy fixed income. Like them, investors who lock in spending goals with bond interest and maturing principal can dedicate the remainder of their assets to long-term growth instead of reaching for yieldacross their portfolio. 

Day-to-day volatility (or price swings) isn’t really risk, which should be measured relative to goals. The lowest-risk asset you can own for a liability due tomorrow is cash, for a liability due in five years a five-year bond,and so on. Looked at this way, higher rates offer an opportunity to meet goals with less capital.

Rising rates are a short-term headwind for bond returns (due to duration risk), but they’re a long-term tailwind as reinvestment risk (the possibility of bond payments needing to be reinvested at lower interest rates) reverses course. Investor impact will depend on the pace of interest rate changes, the rate sensitivity of the bond investment, and the investor’s holding period.

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