Investment decision-making is rarely easy. The stock market is setting new highs? Maybe we should wait for a pullback before investing further. Stock prices are falling? Maybe we should wait for them to pull back some more before investing further. Whether the market is rising or falling, Mr. Market likes to make things tough.
Today's bond market is presenting a similar challenge for some investors. Yields are low and have been for quite some time. If rates rise, then bond prices tend to fall, so maybe it's better to wait before investing further. Maybe so, maybe no. And yes, lower yields on today's bonds should translate to lower expected returns for these bonds in the future. However, do these factors result in high-quality bonds being a poor choice for a diversified portfolio today?
As Figure 1 illustrates, bonds have historically performed reasonably well when the stock market (using the S&P 500 Index as a proxy) did poorly. Notably, not every class of bonds fared well and high-quality bond funds – such as those that make up Morningstar's U.S. Fund Intermediate Core Bond fund category – performed best. If you were wondering, the Vanguard Total Bond Market Index and the Schwab U.S. Aggregate Bond Index funds that our firm recommends for the majority of our clients are in that same category of funds.
Source: Vanguard calculations, using Morningstar, Inc., as of March 17, 2020.
Note: Historical performance of funds based on 2019 Morningstar categorization of funds. Past performance is no guarantee of future returns. The performance of an index or a bond category is not an exact representation of any particular investment, as you cannot invest directly in an index or a bond category.
With yields lower than historical levels, couldn't bond funds perform differently and not provide their historical diversification benefits? Certainly, but similar arguments might have been made prior to the market disruptions demonstrated in Figure 1. In each case, yields were at or below the levels of the then-recent past (Figure 2).
Yields have been led lower in large part due to lower levels of expected inflation. There are multiple measures of US inflation rates, and our purpose here is for demonstration rather than calculation. Therefore, Figure 2 plots a measure familiar to many investors: The U.S. Consumer Price Index. Inflation expectations are important as they are a major consideration for the market's pricing of bonds. As such, it's easy to overlook this very important point – bond yields are not set for investors but by them – and the current yield environment portends investors' beliefs that higher inflation is not something to be feared in the immediate future.
As in life and with investing, complacency is rarely rewarded while conviction often can be. Portfolio Solutions® recommends investment solutions that rely on time-tested risk management and return-enhancement tools. Such tools include diversification, lower costs, and, in the case of our bond portfolios, an emphasis on higher creditworthiness. While we will never be complacent and are always looking for new ways to improve our clients' investment and relationship experiences with our firm, our conviction regarding these three factors remains steadfast.
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All information presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service, nor should it be construed as tax or legal advice. Please click here to see our blog disclosure, which immediately follows the "Applicable Law and Venue" section.