Last year, bonds declined in value, and some surveys revealed that advisors were reducing their bond allocations.
It seemed certain that the Federal Reserve’s tapering of quantitative easing would lead to higher rates. Many predicted the imminent collapse of the bond bubble as investors pulled money out of bond funds. The Pimco Total Return Bond Fund (PTTRX) alone had $41 billion yanked, causing it to lose its title as the world’s largest fund.
While the iShares Aggregate Bond Fund (AGG) declined 1.98% last year, it gained 2.2% through April 12 of this year. What happened was simple.
First, many confused knowledge with unique knowledge. Markets are not stupid and knew the government couldn’t buy its own Treasury bonds indefinitely. Economists, however, have a track record of predicting the direction of longer-term interest rates less accurately than a coin flip.
The second, and even more important, aspect was that bubbles can happen only to risky assets. Yes, bonds lost nearly 2% last year, but stocks have lost 2% on several days this year.
During a shock to the system in which rates on a high-quality intermediate-term bond rose from 2.3% to 6.3% (400 basis points), the AGG bond fund lost about 18.1%. Still, that is less than the stock market lost on Oct. 19, 1987, alone. Unlike with stocks, a bond fund is a laddered portfolio. That 400-basis-point increase means that bonds yielding 2.3% are maturing every month and being replaced with bonds yielding 6.3%. Ultimately, the bond returns will increase for those who don’t panic and sell.
Never forget that stocks are riskier in a day than high quality bonds are in a year. The role of the bond portion of a portfolio is that of a shock absorber. Fear of bond bubbles shouldn’t drive your asset allocation.
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for CBS MoneyWatch.com and has taught investing at three universities.