Blog

Bond Funds in Brief

Thomas BalisJune 28, 2018

Markets

So, what is happening to my bond funds this year?

Many clients are asking this question of late. Indeed, after many years of consistent returns from their bond fund holdings, results in 2018 have been less than stellar.  The Barclays US Aggregate Bond Benchmark (a fair benchmark to analyze bond prices and total returns) has been positive nine of the last ten years…

…but in 2018, it’s down (1.50%) thru May.  So what’s going on, anyway?

It indicates rising rates, right?

Most investors are well aware that as interest rates increase, bond values decrease.  Moreover, bonds with longer duration (interest rate sensitivity) can show sharp decreases in value.  As the Federal Reserve continues on a clear path of raising interest rates, the yield curve has begun to flatten (differences between short term rates and long term rates become narrower).  And, while Fed rate hikes most directly impact the short end of the curve (0 to 2 years), the middle of the curve (3 to 7 years) is not immune to such rises. It’s important to note, our bond funds, which are intermediate in duration, invest there. However, this is not altogether a bad thing.

Higher rates can be good for bond funds

Generally, rising rates are actually a good thing for bond investors over the long term.  Increasing rates mean that newly purchased bonds within the funds are receiving higher coupon payments.  Bond funds are constantly buying new bonds, as they receive cash from inflows, from other bond coupon payments, from bonds being called, and from bonds that mature.  All of this cash gets to be reinvested at higher rates, hopefully improving returns over the long haul. 

 

As the chart shows, the average annualized 3-year forward return is positive at all starting yield levels, so clearly, good things come to the patient investor.

A few more considerations worth noting

First, other fixed income options such as bank accounts, CDs, and money market funds continue to underperform, with relatively low yields just starting to cross over the 1% range.  If you are looking for income, bond yields should still be higher.

Second, bonds have less volatility than stocks.  Everybody remembers the stock market decline of approximately 40% in 2008.

Third, all of our bond funds employ active management, whereby our managers are always looking for ways to improve return and reduce volatility. We feel active management is a big help in volatile times.

Bottom line

Primarily, the bond funds used at HFA are intermediate term bond funds, most of which have modest duration underweights, particularly at the long end of the curve. This means our fund managers are generally avoiding buying bonds with longer terms, for now.  Our actively managed bond fund portfolio managers continue to find attractive bonds from existing issues, and new issues, with more modest durations.  While some investors may seek comfort in very short and limited term funds, returns in those segments remain low, and timing of when to enter or exit can be tricky indeed.  Moreover, we remain committed to investing only in investment grade bond funds, versus high yield or floating rate.  We believe bonds should be the ballast of the portfolio. Credit risks in those other categories can be quite significant.

Clearly, 2018 has been a much different year than 2017, even in the fixed income space.  More than ever, bonds play an important role for diversification within portfolios.  We plan to continue to hold bonds in the fixed income portion of your portfolio. We expect the higher interest rates to be good for bonds over time, and our active bond managers will continue to look for ways to add value to their funds.  In conclusion, bond funds help offset the volatility that can come with equities, particularly when markets are periodically roiled by geopolitics.  As always, we are available to address any specific concerns, and are grateful for the trust you have placed in our firm.