Even Now, There Are Reasons To Own Bonds

If you’re like a lot of investors, you’re probably reviewing your fixed income holdings thinking, You had one job! After all, given their traditionally reduced potential for return, many investors turn to bonds primarily for diversification – a potential backstop should the stock markets turn sour. So when both stocks and bonds plummet, as they have for the first half of 2022, you could be forgiven for second-guessing your exposure to fixed income. Yet doing so might be underappreciating the true value bonds bring to your portfolio. We spoke with John Craddock, CFA®, Baird Trust’s Director of Fixed Income, and Ross Mayfield, Investment Strategy Analyst for Baird Private Wealth Management, about the benefits of fixed income in a down market.

Is It 1980 All Over Again?

When we talk about bond returns, it’s useful to reference “the Agg” – the Bloomberg U.S. Aggregate Bond Index, an across-the-board flagship index that measures all types of investment-grade, U.S. dollar taxable bonds. During the first quarter of 1980 (see Figure 1), the 10-year Treasury rate rose to over 13%, which led to a total return of -8.71%. That performance is echoed by what we experienced in the first quarter of 2022, when the Agg had a total return of -5.93% and was down more than 10% through June 30.

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Figure 1.
Q1 Returns for the Agg, 1976 Through 2022. Source: Baird Trust, Bloomberg

So by this measure, 2022 has seen the worst start for bonds in more than 40 years, rattling many investors who depend on their bond portfolio for stability, reliable income and an offset to stock market drops. And it’s true that making bonds a part of a diversified portfolio typically “smooths the ride” for investors over the long term. But there are times, like we’ve witnessed early in 2022, when both bonds and stocks can fall in value. While this can lead to investor angst, it is important to keep in mind some bond basics and how bonds are different from stocks.

Take Comfort in Coupon and Principal Cashflow

As suggested by the term “fixed income,” bonds are essentially a stream of known cashflows, typically consisting of semiannual interest payments and a principal payment at maturity. These cashflows are not affected by the price movement of the bond, and issuers do not have the option to skip or defer payments, as they do with stock dividends. Investors can take comfort knowing that, even with the current price volatility, actual coupon payments will continue to flow, and – short of outright default – the return of principal gets closer with each passing day, with no sell transaction required. And the best part? Investors get to reinvest their bond proceeds at the higher rates that 2022 has been offering thus far.

(It’s worth noting that we’re making a distinction here between individual bonds holdings and bond funds, which are professionally managed pools of bonds. While the two share some of the same potential diversification and yield benefits, bond funds have fluctuating monthly distributions and no maturity date. Importantly, bond funds can increase or decrease in value, much like stocks – in contrast, individual bonds can be held to maturity, at which point 100% of principal value is returned in cash.)

It's also worth revisiting the relationship between time to maturity and price volatility. Figure 2 depicts the recent price movement of two different bonds from the same issuer, one with a 2022 maturity and the other with a 2029 maturity. Throughout its lifecycle, the 2022 Home Depot bond paid all 14 of its coupons and returned 100% of its principal value on May 1. And while the longer 2029 bond has experienced significantly more price volatility than the 2022 bond, it too has continued to pay regular coupons and is on track for 100% principal return – just like its 2022 cousin. As an investor, you can take comfort knowing that price volatility is only temporary. As it nears maturity, the 2029 Home Depot bond will become less sensitive to interest rate moves, allowing it to steadily pull closer to that $100 par value (also known as the face value of the bond).

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Figure 2.
Bond Price Volatility and the Maturity Date Effect. Source: Baird Trust, Bloomberg

Time: A Bond Investor’s Best Friend

Given the volatile rate environment we are experiencing in 2022, never forget the steady coupon flow and “pull to par” of your bond holdings – both are your friend as a bond investor. And while we never welcome a bad start to the year, it does not have to dictate full-year returns. Figure 3 bears witness that bond returns typically recover somewhat after a challenging beginning to any given year. Note that of the previous 13 negative first-quarter starts for the Agg, in only four did the Agg fail to produce positive returns for the full calendar year.

Figure-3-Full-Calendar-Year-Returns-for-the-Agg-1976-through-2021.jpg
Figure 3. Full Calendar Year Returns for the Agg, 1976 Through 2021. Source: Baird Trust, Bloomberg

It also might serve us well to remember that despite the rough start, the Agg ended 1980 in positive return territory – up 2.71% for the full calendar year! So if 2022 really is a 1980 replay for bonds, we may have some better news coming later this year.

In challenging markets like these, it’s easy to question the effectiveness and utility of keeping a healthy exposure of bonds in your portfolio. Just remember that while there are no sure things in investing, with each passing day bond investors get one day closer to their next semiannual interest payment or return of principal. There’s something to be said about allowing time to be our friend, collecting bond coupons and principal cashflows as we go and reinvesting them at potentially higher rates of return. Your Baird Financial Advisor would be happy to sit down with you and discuss the role bonds play in your own portfolio.

The information reflected on this page are Baird expert opinions today and are subject to change. The information provided here has not taken into consideration the investment goals or needs of any specific investor and investors should not make any investment decisions based solely on this information. Past performance is not a guarantee of future results. All investments have some level of risk, and investors have different time horizons, goals and risk tolerances, so speak to your Baird Financial Advisor before taking action.