A serious decision facing advisors and investors is whether to rid their portfolios of bonds. With interest rates at extraordinarily low levels, many experts understandably expect rates to rise at some point. When interest rates rise, bond prices fall, of course. That means holding bonds would seem to be a pretty bad idea.

But rates alone are not the sole factor that needs to be considered. The ultimate measure for an investor is the total return of a bond or bond mutual fund.

With that in mind, consider the average return each year for all publicly available intermediate-term U.S. bond funds over the past 36 years. In this period, the federal funds rate increased during 17 years and decreased in the other 19 years. (The federal funds rate is the interest rate at which depository institutions lend balances to one another overnight.)

The history of the federal funds rate from 1976 to 2011 is shown in the chart on the next page. It depicts how the overall trend of the federal funds rate has been one of decline. Nevertheless, since 1976, the number of calendar years in which the rate increased nearly equaled the number of years in which the rate decreased.

The average return for all U.S. intermediate-term funds (the Morningstar category average return) in the 19 years when the federal funds rate decreased was 9.84% (with a median return of 7.64%). The average return for the intermediate-term bond category in the 17 years in which the federal funds rate increased was 5.93% (with a median return of 4.7 %).

As theory would dictate, bond funds indeed performed better in years when the interest rate decreased, but an average annual return of nearly 6% in those years when interest rates increased is impressive. The average size of the rate change in years when the federal funds rate increased was 136 basis points, while the average change in years of decreases was 152 basis points. Thus, the average upside and downside change in the annual interest rate was reasonably close.

The 36-year history of the federal funds rate as well as the average return of all intermediate-term U.S. bonds is summarized in the "Interesting History" chart on page 98, which highlights the years in which the interest rate increased. Notice that in only one of the highlighted years - 1994 - was the average return negative for this category of bonds. During 1994, the federal funds rate increased to 4.21% from 3.02% , a rise of 119 basis points. On average, intermediate-term U.S. bond funds had a return of -4.01% that year.

Notably, the average bond fund was negative in two years when interest rates declined (1999 and 2008). In 2008, there were clearly issues of bond quality that came into play.

The experience of the past 36 years suggests that the total return for intermediate bond funds, on average, is influenced by multiple factors and not solely the direction of change in interest rates.



But what if investors had had perfect knowledge of where interest rates were headed? Could they greatly improve a portfolio's returns?

Imagine a multi-asset portfolio that avoids holding bonds during years in which the federal funds rate increases. This multi-asset portfolio consists of equally weighted allocations of large U.S. stocks, small U.S. stocks, non-U.S. stocks, U.S. bonds, U.S. cash, real estate and commodities. During the 19 years since 1976 that the federal funds rate declined, this multi-asset portfolio held 14.3% in each of the seven assets.

Alternatively, during the 17 years in which the federal funds rate increased, the multi-asset portfolio avoided bonds completely and held a double allocation in cash (or 28.6% of the portfolio). This represents a "perfect knowledge" portfolio that knew when not to hold bonds in the portfolio - at least according to conventional wisdom. For this experiment, the performance of U.S. bonds was represented by the Barclays Capital Aggregate Bond Index, which has a very high correlation to the performance of intermediate-term bonds.

What were the results of a portfolio that avoided holding bonds in all the years in which the federal funds rate increased and held bonds in all the other years? Since 1976, this "perfect knowledge" portfolio had an average annualized return of 10.65%. This performance figure assumes rebalancing at the end of each year. (If using the category average return for U.S. intermediate-term bonds instead of the Barclays Capital Aggregate Bond Index, the average annualized return was 10.6%.)

By comparison, if this very same multi-asset portfolio simply held all seven asset classes in equal proportions of 14.3% and rebalanced at the end of each year (meaning that the portfolio never excluded bonds in any year), it achieved a 36-year average annualized return of 10.64%. All three portfolios had virtually identical 36-year standard deviation of return.

Did avoiding holding bonds at the "perfect" times improve the overall portfolio performance? No. Did it hurt the portfolio's performance? No. Did it require perfect knowledge? Yes. Is it reasonable to assume that any investor or advisor could time when and when not to hold bonds in their portfolio perfectly? No.

Simply put, recent history does not support the notion of attempting to time when and when not to hold bond funds in a multi-asset portfolio. Bonds are a fundamental asset class that warrants inclusion in a diversified portfolio at all times.

With that established, it is still important to diversify the types of bonds that are included in a portfolio. In addition to an aggregate U.S. bond fund, it would be prudent to include a TIPS fund and a non-U.S. bond fund. A high-yield bond fund might also be appropriate.

The key is recognizing that consistent diversification is a fundamental tenet of successful long-term investing, whereas all-in or all-out asset class timing is not. In the current investing environment, it is vital to approach bonds with this mind-set.



Craig L. Israelsen, Ph.D., is a Financial Planning contributing writer and an associate professor at Brigham Young University. He is the author of 7Twelve: A Diversified Investment Portfolio With a Plan.

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