When people think of investing most think of the stocks of companies in the Dow Jones Industrial Average or the S&P 500. However, almost all our clients’ accounts have bonds too as part of a well-diversified portfolio. Bonds (Fixed Income) are debt securities issued by companies, state and local governments, and the U.S. Federal Government that obligates the issuer/borrower to pay interest to the lender/investor for a specific time period and then reimburse the original principal amount at the end of that time.
Bonds have existed for over 4,000 years. The first recorded bond in history was literally carved in stone in 2400 BC and was discovered at Nippur, Mesopotamia, now present-day Iraq. The first government bond was issued by the Bank of England in 1693 and the first US Government bond was issued to finance the Revolutionary War, quite fittingly. Private individuals showed a determined confidence in our young county and bought $27 million in bonds.
Portfolio Construction:
Historically, bond and stock prices have been inversely correlated. In other words, if bond market prices are rising, then interest rates are probably dropping (more on that later), the economy is probably stagnant, and stock prices are dropping. Further, whereas stocks have an average return of around 11% per year from 1950-2015, bonds have returned approximately 6% over the same timeframe. In addition, stocks may have a higher average annual return, but the tradeoff is significant volatility. One measure of market volatility is the standard deviation of the individual annual returns. Stocks have an average annual volatilely of ±16% and bonds ±3%. Therefore, for example, using ±3 standard deviations to represent volatility, stocks could return around 11% in any one year ±48% (16% x 3). That’s a range of -37% to +59%. Bonds on the other hand could return 6% per year ± 9% (3% x 3). That’s a range of -3% to +15%.
Although all investing is risky, having both stocks and bonds in a portfolio allows their inverse correlations to potentially lower the overall volatility of the portfolio. If someone wanted to maximize growth and was not concerned about portfolio volatility, he or she could invest in a portfolio of 100% stocks and the just sit back and enjoy the roller-coaster ride. Sir John Templeton said, “The only investors who shouldn’t diversify are those who are right 100% of the time.” However, our clients have spent time looking forward to the future, contemplated their long-term goals and objectives, and have determined that a more diversified, less volatile portfolio gives them the best opportunity to live the life they envision. They don’t want or need to be exposed to any higher risk in their portfolio.
Bond Pricing:
As mentioned above, changes to interest rates have the greatest influence on bond prices. On September 30, 1981, the 10-year US Treasury yield hit a 60+ year high of 15.84%. Since 1981, Treasury yields have been on a 35-year downward trend and on October 31, 2016, stood at 1.83%.
New bonds are issued at current market rates. For example, say the current interest rate for a new 5-year bond is 6%. That means a par value $1,000 bond will pay $60 per year for 5 years and then return the par value, $1,000, to the investor/lender. However, if over the next couple of years, interest rates continue to drop, then new 3-year bonds may only pay 2%. So, for $1,000 bond that has a $60 coupon payment for three more years, discounted at the then current interest rate, 3%, the bond would be worth approximately $1,100. If interest rates had gone up over the last 2 years, the bond would be worth less that its par value. Bond prices and interest rates enjoy an inverse relationship too. This “present value” calculation could also take into account multiple other factors besides interest rate risk such as credit risk (the credit worthiness of the issue/borrower), if the bond can be called or redeemed sooner, current and anticipated inflation rates, priority of claims to any collateral, and monetary policies.
We hope you’ve found this review to be educational and helpful. As we like to emphasize, it is our job as financial advisors to assist you. Thank you very much for the trust and confidence you’ve placed in our firm. We treasure our relationships with our clients, and seek to serve a few more people like you. If you know of someone who would benefit from our advice and services, we would welcome an introduction.
We wish you a wonderful Thanksgiving holiday.
DISCLOSURES: The information provided in this letter is for general informational purposes only and should not be considered an individualized recommendation of any particular security, strategy or investment product, and should not be construed as investment, legal, or tax advice. The Nalls Sherbakoff Group, LLC makes no warranties with regard to the information or results obtained by third parties and its use and disclaim any liability arising out of, or reliance on the information. These indexes reflect investments for a limited period of time and do not reflect performance in different economic or market cycles and are not intended to reflect the actual outcomes of any client of The Nalls Sherbakoff Group, LLC. Past performance does not guarantee future results.