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April 5, 2016

Understanding the role of bond funds today

The bond bull market has been about as good as it gets for almost four decades now. No bond fund marketing pitch today will be without a reference to their excellent historical performance. However, due to simple bond math, past performance cannot be repeated because interest rates were on a one-way train down to nearly zero. The bull market in bonds may not be completely over, but it is definitely on its last legs. Future returns of bond funds will be modest, at best. But bond funds can still play a role in your portfolio.

When the yield is lower than the fees of your bond fund

Nearly 65% of all global government bonds now yield less than 1,0%. Approx. 30% even yield less than 0%, i.e. they are in negative territory.

JPM

Here are just some examples of 10 year government bond yields:

  • Switzerland -0.4%
  • Japan -0.1%
  • Germany 0.1%
  • Italy 1.2%
  • UK and Spain 1.4%

Are term deposits a good substitute?

Banks are now offering higher yields on their term deposits than what investors can get as effective yield in their bond fund. But before investors rush out of bond funds, they should consider the following differences:

  • Safety: Investor protection is different for term deposits than it is for bond funds.
  • Liquidity: Investors are locked up for the duration of the term deposits while bond funds offer daily liquidity.
  • Total return: There are scenarios where a bond fund can offer higher returns, despite a lower starting yield. Accelerating global deflation after a large China renminbi devaluation could be such a case.

So what’s an investor to do about their bond portfolio?

We should re-frame the question: what is it that investors expect from the bond portion of their portfolio?

  • Inflation protection?
  • Income?
  • Hedge against stock market turmoil?
  • Diversification benefits?

Once you figure out the answers to this question, it will be easier to define what bond strategies are right for you.

With yields so low, should investors even be in bonds?

This is a legitimate question and many large investors are now advocating a reduction of the bond allocation. Warren Buffett, one of the most successful investors, has determined in his last will, that his assets should be 90% in equities and only 10% in bonds. The largest sovereign wealth fund, the Norwegian Pension Fund, has recently announced that they will reduce their bond holdings. But should private investors follow? We think there is one very important reason to own bonds (or bond funds) that rarely gets mentioned: a bond allocation helps protect a portfolio from its owner! Investing in bonds is a hedge against bad investment decisions. Bonds may not earn a high return but their stability will stop some people from doing the wrong thing at the wrong time. A portfolio with a bond allocation helps reduce behavioral risk and leads to a higher probability for long-term success

Summary

Bond funds still play an important role as a portfolio stabilizer. However, investors should probably avoid short-to-medium term maturities where yields are nearly universally negative. Investors should also be careful of the siren song of corporate bond funds. Although they offer higher yields, they offer much less stability than government bonds. In our view, the bond part of your portfolio should offer stability and act as a shock absorber when equity volatility hits. But corporate bonds tend to sell-off at exactly the same time when equity markets are weak. Invest in equities to grow your wealth and invest in government bonds to protect your wealth. Corporate bonds are a hybrid and a well structured portfolio does not require corporate bond holdings.

The situation we are currently in with very low interest rates makes one point very clear: you need to control the costs of your bond fund! A 1% annual management fee used to be acceptable, when bonds yielded more than 6% (remember those days?). However, today the math no longer works as nearly 2/3 of all global government bonds have a yield below 1%.

As always, you can email us if you would like to discuss any of these topics and how they apply to your personal situation.

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