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While the stock market typically captures most of the newsprint and the lion’s share of commentaries from pundits, bonds are key holdings in all our portfolios. Many of our clients look to bonds for portfolio protection, capital preservation, and/or a regular income stream to meet their current and future spending needs. Beyond these important benefits, bonds have significantly lower downside risks versus stocks.
Bonds are not one-size-fits-all investments though. Depending on a client’s investment preferences, their time horizon, and the investing environment, we may recommend a range of fixed-income vehicles: core bonds (investment-grade government, corporate, and mortgage), flexible and absolute-return-oriented bond funds, and floating-rate loan funds. For clients in our balanced portfolios, fixed-income investments currently make up about 36.5% of holdings. Just looking at allocations though does not explain why we are positioned the way we are within fixed-income.
Our decision to shift more than half of our clients’ fixed-income exposure into flexible and absolute-return-oriented bond funds as well as floating-rate loan funds a few years ago was based on the limited return potential we saw for core bonds during a period of ultra-low interest rates. Yet, even though the Federal Reserve has begun raising interest rates to more normal levels, we have maintained our positioning. One reason for this is that these other types of fixed-income securities still look very attractive when compared to core bonds. Specifically, their higher yields provide more of a cushion against falling prices—bond prices fall as interest rates rise—and they show less sensitivity to interest rates. This much lower sensitivity means their prices face less of a hit from rising interest rates than core bonds do.
There is a catch. These types of investments come with greater credit risk, which means they are more vulnerable to losses during a market downturn. Even so, they offer an attractive balance of risk and reward that should enhance diversified portfolios. For instance, in the case of floating-rate loans, investment supply and demand dynamics are healthy and default rates are currently low. Additionally, the loans are secured by the borrowing company’s assets, and the interest rates paid adjust (float) at specified intervals in response to fluctuations in market interest rates. We have confidence in the ability of all our active fixed-income managers to navigate the risks.
We anticipate returns for more flexible bond funds as well as for high-quality floating-rate loan funds will far exceed those for core bonds. And our recent portfolio performance has borne this out. The core bond index returned only 2.5% in 2016; all but one of our fixed-income funds beat that, with returns ranging from 4.5%–8%. The first quarter of 2017 saw the same performance trend.
As interest rates rise, and assuming the global economy stays on its current growth trend, we expect core bond returns to remain low to negative and overall portfolio returns to continue to benefit from our positioning. As usual, we won’t rest on our laurels. We’ll continue to assess our fixed-income positioning so that if and when the investing environment shifts, we’ll be prepared to shift with it to ensure our portfolios stay resilient and optimized to meet their investment goals.
—Litman Gregory Research Team
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