Bonds have had a tough year. The Barclays U.S. Aggregate Float Adjusted Index recorded a total return of -2.77% year-to-date through August 31, 2013. Concerns that the Federal Reserve may end it’s support of the economy through the purchase of bonds has helped depress bond prices. It may also be caused by the normal turn of the cycle. Interest rates have been below historical averages since 2008. Whatever the reason, investors are questioning the wisdom of holding bonds during what looks to be a rising interest rate environment.
We believe bonds provide an important role in an investment strategy and that role does not change. Their first role is to provide liquidity. Our bond portfolios have staggered maturities no longer than five years. The goal is to have an equal amount of bonds maturing every twelve months. Liquidity is provided as the bonds mature on a regular basis – usually about every three months. This reduces the need for a client to hold a sizeable amount of money in cash (at current yields of < 1%). Maturing bonds provide cash for planned purchases, as well as cash to buy equities in down markets to rebalance the portfolio.
Secondly, the bonds help to stabilize the portfolio and minimize volatility. When equities are moving higher, rebalancing allows us to capture some of the gains and add them to the bond ladder. The opposite occurs when equities prices are falling. Rebalancing provides the discipline to buy equities when prices are down. This discipline helps to smooth out some of the volatility.
Finally, building a bond ladder with the intention of holding the bonds until they mature avoids potential losses, as long as the issuer doesn’t default. The bond’s market price may decline when rates rise, but the value at maturity doesn’t change. Incorporating bonds in this type of investment strategy works effectively in all markets.