Conventional wisdom says that when stocks fall bonds (particularly Treasurys) will pick up the slack. During April’s tariff announcements, however, stocks tumbled as expected, but bond yields rose, meaning their prices fell and didn’t come to the rescue. For many investors (and some advisors) it felt like 2022 déjà vu when both stocks and bonds tanked by double digits amid high inflation and a series of Fed interest-rate hikes.
Some clients may be fearful that bonds are no longer a reliable hedge against stock market volatility. I wouldn’t go that far, but now might be a good time to review the myths and misconceptions about bonds with your clients.
Seven Common Misperceptions About Bonds
1. Bonds are always safe. While it’s true that bonds are generally less volatile than stocks, they are not risk-free. When an investor purchases a bond, they lock in a coupon rate and a maturity value. But a lot can happen between the purchase date and the sell date. If your client plans to hold the bond to maturity, they’re exposed to the risk of inflation and loss of purchasing power. But that’s not all. Suppose the issuer runs into financial problems and defaults? Credit risk is priced into the coupon rate. The higher the risk, the more the issuer must pay to attract money. Advisors must be aware of the risks associated with the term of the bond and the credit risk.
For instance, a 10-year bond earning 5% with a AA credit rating and a two-year bond earning 5% with a AA credit rating, face entirely different risks if interest rates rise. The liquidation value will be impacted much more for the 10-year bond than for the 2-year. This is called duration risk. The longer the duration, the more a bond’s price will fluctuate in response to interest rate changes. Generally, bonds will state their duration risk. If the duration risk is 4%, that means for every 1% rise or fall in the interest rates, the bond value will adjust by 4%. So, a bond with a face value of $100,000 would be expected to decline to $96,000 if the interest rate went up 1%. But remember, if you hold the bond to maturity, you receive the full face value.
2. Rising interest rates always hurt bonds. While it’s true that higher rates can negatively affect the price of existing bonds, it also means there are opportunities to invest for higher yields, thus benefiting long-term investors. Additionally, if the general economic climate suggests that rates will come down, buying a 30-year bond with a 20% discount to its maturity value represents a substantial opportunity to see appreciation in the bond value, and the investor receives the coupon rate.
3. Bonds are only for retirees. Bonds can play a crucial role in portfolio diversification for investors of all ages since fixed income helps to balance risk and provide steady income. Your client’s risk capacity—the amount of risk they can tolerate given their time horizon is often very different from their risk tolerance—their comfort level with short-term volatility like we’re seeing today. Even for young investors and others who have a high risk tolerance and/or long time horizon, a modest allocation to bonds can help insulate against stock volatility in a portfolio without giving up too much upside.
4. Government debt causes bond yields to skyrocket. Everyone is concerned about the federal government’s nearly $2 trillion deficit. Sure, large deficits can influence interest rates, but bond yields are determined by many factors, including investor demand and Federal Reserve policy. Some clients may fear a U.S. government default on its obligations, thus making all outstanding Treasurys worthless. While anything can happen, a government default would have a catastrophic global impact and seems unlikely. Generally, our firm stays short-term in its bond portfolios to minimize duration risk. But in times when interest rates are likely to drop a full 100 to 200 basis points, investing in 30-year Treasurys can be an exceptionally good option.
5. Corporate bonds are too risky for retirees. Unlike investors in Treasurys, investors in corporate bonds must evaluate credit risk as well as the duration risk. Highly rated corporate bonds can be a valuable part of a diversified bond portfolio since they typically offer higher yields than U.S. Treasurys. Plus, the income stream is predictable and the default rate, while higher than for Treasurys, is relatively low when compared to junk bonds and other lower-rated corporate debt.
6. Individual bonds only make sense for very large investors and institutions. Conventional wisdom is that an investor needs significant capital to achieve diversification with bonds and that they must constantly monitor which of their bonds are maturing. However, holding individual bonds (instead of bond funds) can offer be advantageous to all-size investors. Here are three reasons why:
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Predictable returns since your client receives fixed interest payments and since the principal is paid back in full at maturity, assuming there is no default.
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Control. You can choose specific bonds that allow customization based on credit, maturity and industry.
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Tax benefits. Taxable bonds generate interest income taxed at ordinary income rates (federal and state), especially if the bonds are sold for a profit before maturity. But if your client holds a bond until maturity, they avoid capital gains tax since their return is considered a return of basis, not a gain. Clients can also eliminate income taxation on bonds by investing solely in Treasurys (not taxed at the state or local level) and municipal bonds (tax-free at the federal and sometimes at the local level).
7. Bond funds offer no control to individual investors. Unlike with individual bonds, your client cannot hold the bonds inside a bond fund to maturity—or sell them prematurely if they wish. Further, bond fund returns are unpredictable. The income will vary depending on the mix of holdings based on coupon rates at the time of purchase. The more interest rate volatility there is, the more the range of monthly distributions will vary. Just know that funds buy and sell their holdings based on interest rate movements and capital inflows and outflows. Most investment managers hold bonds to maturity inside their fund. But because of the fund’s wide diversification, the bond maturities will vary depending on the date of purchase. However, bond funds offer several advantages:
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Diversification, which is very hard for smaller individual investors to achieve. Bond funds hold a large portfolio of investments, which mitigates the impact of defaults.
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Liquidity. While an investor can sell individual bonds, there is a process involved, and it might take time to find a buyer. With a bond fund, the investor can liquidate in one day.
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Lower transaction costs. Bid-ask spreads are typically larger for small transactions, which can translate to lower returns for your clients. Institutional asset managers, which buy and sell large quantities of bonds, can command higher prices for sales and lower prices for buys. This can add up to a transaction cost advantage over individual bond portfolios.
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Professional management. Fund managers can find opportunities to buy bonds at discounts to take advantage of interest rate flow. This is very hard for individual investors to do.
Conclusion
In the final analysis, bonds are an important financial instrument for building a predictable income strategy for clients. Just make sure your clients understand that what they see is not always what they are going to get.
