Stock markets across the globe fell sharply during the first few weeks of 2016. After years of strong stock market performance, downturns like these remind investors of the importance of diversification and disciplined portfolio construction. Even though interest rates remain near historic lows, bonds remain an important part of this diversification as adding them to portfolios lowers volatility (i.e. risk). Historically, high quality bonds, that is those with lesser credit risk, proved an important source of diversification during periods of equity market stress, offering lower correlation while their lower quality brethren tend to have returns more highly correlated to stock market returns. Lower quality bonds imply greater credit risk, which is the risk of not getting paid because the issuer goes bankrupt.
Whenever the outlook for the stock market is threatened, investors will sell risky assets to buy safe investments. This ‘flight to quality’ behavior is a well-known herding reaction to bad news. Historically, owning high quality bonds provides a diversification boost during periods when portfolios need it most. At Crestwood, we include high quality bonds in portfolios to provide a ballast against equity risk which helps to offset periods of stock market stress.
Despite these attractive qualities, concerns over lower expected returns and potential interest rate increases have reduced the appeal for quality bonds. Unfortunately, the near historically low current yields for bonds is suggestive of low future returns (see Perspectives 5/1/15). In addition, the Federal Reserve is on a path to reduce their aggressively stimulative policy of near-zero interest rates. In December 2015, they increased the federal funds rate for the first time since 2006. When interest rates rise, bond prices fall, because most bonds have fixed interest payments and higher rates make these fixed interest payments less valuable. So, not only are lower returns expected, but depending on the pace of future increases in interest rates, it is possible that returns for some bonds could be negative. Continue reading