May 1, 2014
IN DEFENSE OF BONDS
"Some investments do have higher expected returns than others. Which ones? Well, by and large they’re the ones that will do the worst
in bad times."
-William F. Sharpe
Interest rates are moving upward from extraordinarily low
levels, marking what appears to be the end of an
unprecedented 30-year bull market in bonds. The most
frequent question asked of fixed income managers,
including us, is: With interest rates poised to rise, why own
bonds? In this paper, we take an updated look at the
traditional reasons investors own bonds—safety, income,
liquidity, and diversification—and how the market factors
underlying these reasons have changed throughout the
years. In an upcoming paper, we will consider what a fixedincome “bear” market might look like, and how the tools of
active management can be applied to reduce interest-rate
risk in a rising rate environment.
SAFETY
A primary reason to own bonds is that bonds are generally
quite safe. If bought and held to maturity, bonds can
provide a largely uneventful investment experience.
Historical default rates for investment-grade U.S. bonds are
extremely low. According to Moody’s Investors Service, the
average one-year default rate for bonds rated BBB and
higher was 0.26%, or about one-quarter of one percent, for
the period 1970–2012. If a default is on the horizon,
investors usually receive plenty of warning. Among
companies that have defaulted, the median time to default
for A-rated companies was 11 years; for BBB-rated
companies, it was 8 years.2 US Treasury bonds, of course,
have never defaulted and are considered among the safest
investments in the world.
Because bonds can be bought and held until maturity,
bonds can also provide a return that is largely known. The
yield-to-maturity on a 10-year Treasury note, for instance,
is a reasonable approximation of the return on that
Treasury if the note is held to maturity and the coupons are
reinvested at current market rates. In ten years, the
1
treasury matures and the principal amount is returned to
the investor. All other investments, with the exception of
cash and cash substitutes, are subject to ongoing price
and/or income risk.
The safety bonds provide becomes paramount when
markets are shocked by a financial crisis. Steep stock market
losses and financial crises have occurred regularly
throughout the past few decades—typically, every 4 to 6
years. The early 1980s witnessed the Latin American debt
crisis, Black Monday in 1987, and the US Savings & Loan
crisis from 1989–1991. The early 1990s began with a
recession, and the decade was punctuated with economic,
debt, and currency crises in Mexico (1994), Asia (1997), and
Russia (1998). Since the turn of the 21st century, the US
experienced another recession (2000), the bursting of the
dot-com bubble (2001), the largest terrorist attack on US
soil in history (2001), the bursting of the housing bubble
(2007), the global financial crisis (2008), the Great Recession
(2007–2009), and the European sovereign debt crisis (2011).
Few, if any, of these events were foreseen, and during each
of these crises investors sought the safety of U.S. bonds.
Markets will continue to be disrupted by crises, and bonds
will continue to provide a safe haven during periods of
turmoil.
INCOME
Traditionally, bonds have been a source of stable income for
investment portfolios. The interest income from a noncallable, fixed-rate coupon bond is known at the time of
purchase and remains unchanged until maturity.
Environments of prolonged falling interest rates are the
most challenging for investors who rely on portfolio income
to meet their investment goals because maturing bonds
must be replaced with bonds that have lower yields.
For Financial Professional Use Only. Not For Public Distribution.
th
Boyd Watterson Asset Management, LLC — 1801 East 9 Street, Suite 1400, Cleveland, OH 44114 — www.boydwatterson.com
Investors who employ an active management strategy can
benefit during these periods by realizing capital gains
generated by rising bond prices.
The environment facing investors today is in many ways
more difficult given that interest rates are unlikely to revisit
their historic lows. Short-maturity rates are anchored by a
zero–0.25% federal funds rate and long-maturity yields have
been pushed down by a series of quantitative easing moves.
An overall trend of higher interest rates during the next few
years would result in greater coupon income from bonds,
but that increased income will come at the expense of
declining bond prices.
It is possible, however, for higher income to offset the price
declines that accompany rising interest rates, as shown in
Figure 1. The chart depicts the cumulative total returns for
the Barclays Capital Aggregate Bond Index and the S&P 500
Stock Index (shown on the left axis) plotted against the 10year Treasury yield (shown on the right axis) from 1976
through 2013. The Barclays Aggregate had positive returns,
for example, despite increases in the 10-year yield during
the years 1987, 1996, and 2003 because income from the
index’s bonds was greater than the index’s overall price
declines. Income also helps smooth returns; the returns of
the Aggregate Index are far less volatile than those of the
S&P 500.
Figure 1: The 10-Year Treasury Yield and
Cumulative
Returns for the Barclays Capital %
$
2500
Aggregate Bond Index and the S&P 500 Index, 18
1976 through 2013
16
Whether rising income can compensate for falling prices
depends on the magnitude of the interest rate increase and
the speed with which it happens. If rates rise slowly over a
period of years, it is plausible that increasing income and the
accretion in prices from bonds that are “rolling down” the
yield curve will offset price declines, and the aggregate bond
market will have a positive return. Larger coupon payments
can also lead to more reinvestment income. Because today’s
interest rates are very low, however, initially it may be
difficult for rising income to offset declining prices unless
interest rates move upward gradually.
The exceptionally low bond yields of the past few years have
prompted many investors to seek higher income, as well as
greater diversification and price appreciation, from illiquid
or semi-liquid alternative assets such as real estate, private
equity, hedge funds, and emerging markets. Lessons learned
from the global financial crisis include the realization that
the liquidity of many alternative assets can be lower than
estimated, and that these assets may not provide adequate
diversification during market downturns. The presence of
these alternative assets in a portfolio reinforces the need for
adequate liquidity from traditional investments.
Harvard University serves as a useful, if extreme, illustration
of the perils of the pursuit of higher income at the expense
of adequate liquidity. During the financial crisis, the
university’s endowment-model portfolio, heavily weighted
in alternative assets, suffered significant losses and failed to
generate enough income or liquidity to meet spending
obligations. To resolve its income crisis, Harvard issued more
than $2.5 billion of debt.3 Reliable coupons or scheduled
maturities from a stable bond portfolio are the most assured
ways to generate portfolio income to meet liabilities.
Aggregate
2000
SPX
10yr Tsy Yield
1500
1000
14
LIQUIDITY
12
Liquidity is generally defined as the ability to transact on
demand at market prices without causing price dislocation.
Conventional bonds have traditionally been a primary
source of liquidity for investors, providing income and price
return in lieu of cash holdings but with the surety of the
ability to raise cash on short notice. Treasury and agency
bonds, for example, can be sold for “same-day” settlement
when the sell order is placed in the morning.
10
8
6
500
4
2
0
Source: Barclays and Bloomberg
Past performance is no guarantee of future results.
0
During the financial crisis, many securities previously
considered liquid could not be sold at any price. Treasuries,
government agencies, and some high-quality corporate
bonds were the few types of securities that had not suffered
extreme price losses and could be sold if needed. Keeping a
For Financial Professional Use Only. Not For Public Distribution.
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Boyd Watterson Asset Management, LLC — 1801 East 9 Street, Suite 1400, Cleveland, OH 44114 — www.boydwatterson.com
portion of one’s investment portfolio in liquid securities not
only enables investors to meet liability obligations but also
affords the ability to take advantage of rare market
opportunities to purchase assets that may be significantly
undervalued when prices plummet.
Since the financial crisis, several contributing factors have
altered the nature of liquidity in the capital markets:
 Changes in regulation – Broker/dealers have
severely curtailed the amount of inventory they are
willing or able to hold on their balance sheets in
order to meet new risk-management guidelines
related to proprietary trading.
 Changes in market participants – The prevalence of
“well-informed” traders such as high-frequency
traders and hedge-fund managers has grown, and
these traders can create above-average volatility
that at times can impact market liquidity. Similarly,
leveraged investors may be forced to liquidate
assets to meet margins calls and such forced selling
may distort the prices of even liquid stocks and
bonds.
 The popularity of ETFs – In contrast to wellinformed traders, ETFs engage in indiscriminate
buying and selling. When forced to liquidate assets,
ETFs must sell regardless of market price. Similarly,
ETFs must buy regardless of price, often bidding up
prices on bonds that active managers would deem
too expensive. Large-scale selling, such as during a
market crisis, could lead to rapidly falling prices and
a liquidity crisis if dealers decline to take the bonds onto
their balance sheets.
As markets have evolved and market participants have
changed, an allocation to high-quality, liquid, fixed-income
securities is perhaps of even greater importance today.
Active management can help determine which securities are
less likely to be affected by indiscriminate trading, as well as
monitor market conditions for changes in liquidity trends.
DIVERSIFICATION4
Bond investors often win by not losing. Figure 2 shows
annual returns for the Barclays Capital Aggregate Index
versus the S&P 500 Index for the years 1976–2013. Equity
returns periodically soar upwards of 20%, but bond
investors saw such lofty returns only twice in the past 40
years–in 1982, when the Barclays Aggregate returned
32.6%, and in 1985, when the Aggregate returned 22.1%.
Yet bond investors were also spared steep losses, such as
the 13% decline in equities in 2001—bonds were up 8.4%—
and the 23.4% bear market of 2002, when bonds were up
10.3%. In 2008, aggregate bond investors enjoyed a
respectable return of 5.2% as the S&P 500 Index plunged
38.5% in value. During the time horizon depicted in the
chart, bond investors experienced three years of annual
losses, totaling –5.7%, whereas equity investors experienced
eight years of annual losses, totaling –114.7%. The largest
loss to aggregate bond investors was –2.9%, in 1994. During
this period of nearly 40 years, each negative year of
performance in the bond market was followed by a return
to positive performance in the next year.
Figure 2: Annual Total Returns for the Barclays Capital Aggregate Bond Index and the S&P 500 Index
40.0
30.0
20.0
10.0
0.0
(10.0)
(20.0)
(30.0)
S&P Index Returns
(40.0)
Aggregate Index Returns
(50.0)
Source: Barclays and Bloomberg
Past performance is no guarantee of future results.
For Financial Professional Use Only. Not For Public Distribution.
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Boyd Watterson Asset Management, LLC — 1801 East 9 Street, Suite 1400, Cleveland, OH 44114 — www.boydwatterson.com
Bonds provide much-needed downside protection and
diversification not only for equity portfolios but also for
portfolios diversified well beyond the traditional 60/40
portfolios of the past. Figure 3 shows the correlations for
domestic fixed income relative to asset classes commonly
found in today’s institutional portfolios. The equity risk
factor remains present to a large degree in all of these
alternative choices, but the correlation of bonds with other
asset classes is extremely low–and is negative for equities.
Bonds remain a powerful diversifier.
Figure 3: Correlations between Major Asset Classes for the 15 Years Ended December 31, 2013
US Equity
US Equity
International Equity
Emerging Markets Equity
Real Estate
Emerging Market Fixed Income
US High Yield
US Fixed Income
1.00
0.87
0.78
0.60
0.56
0.64
-0.08
Emerging
Markets
Equity
International
Equity
1.00
0.86
0.60
0.63
0.68
0.02
1.00
0.52
0.68
0.69
0.01
Real
Estate
1.00
0.49
0.62
0.14
Emerging
Market Fixed
Income
US
High
Yield
1.00
0.68
0.38
1.00
0.19
US Fixed
Income
1.00
Source: Bloomberg, Merrill Lynch Indices and Barclays. Indices represented by S&P 500, MSCI EAFE Index, Dow Jones Equity REIT Index, ML USD EM Sovereign
Index, ML US High Index and B/C Aggregate Index. Correlations calculated from 15 years of monthly data ended December 31, 2013.
CONCLUSION
Bonds continue to be an indispensable part of every
investor’s portfolio. Within the bond universe many choices
exist for structuring a portfolio to express an investor’s
desired risk parameters and expected returns. All bonds are
not created equal, however, and investors must consider
the risks of various structured, securitized, and lower
quality bonds versus the liquidity and safety offered by
traditional fixed income. A well-constructed bond portfolio
can deliver safety, income, liquidity, and diversification
through challenging and diverse economic environments.
NOTES
1
William F. Sharpe as quoted in Money Magazine’s July 6, 2007 issue
2
Moody’s Investors Service. 2013. “Annual Default Study: Corporate Default and
Recovery Rates, 1920–2012.” Moodys.com (28 February).
3
Ang, Andrew. 2011. “Illiquid Assets.” CFA Institute Conference Proceedings
Quarterly, vol. 28, no. 4 (December):12–22.
4
Diversification does not guarantee a profit or protect against loss.
Deborah Kidd, CFA
Robert Fernald
Travis Dragan, FRM
For Financial Professional Use Only. Not For Public Distribution.
th
Boyd Watterson Asset Management, LLC — 1801 East 9 Street, Suite 1400, Cleveland, OH 44114 — www.boydwatterson.com