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Market Recap – Should You Keep Bonds in Your Long-Term Portfolio?

Market Digest – Week Ending 2/24/2017
U.S. equities continued to rise coming off the three day weekend, followed closely by their foreign counterparts. Stocks subsequently flat lined as investors digested the latest Fed minutes, but a late-Friday rally pushed US markets higher for the week. Treasuries, gold and real estate all ended the week in positive territory, while foreign stocks and commodities were down.

Weekly Returns:
S&P 500: 2,367 (+0.7%)
FTSE All-World ex-US: (-0.2%)
US 10 Year Treasury Yield: 2.31% (-0.10%)
Gold: $1,257 (+1.8%)
USD/EUR: $1.056 (-0.6%)

Major Events:

  • Monday – President’s Day
  • Tuesday – Verizon announced it would still buy Yahoo’s core business, but lowered its offer by $350 million due to recent cyberattacks
  • Tuesday – The owners of Burger King and Tim Hortons announced it would acquire Popeyes Louisiana Kitchen for $1.8 billion in cash
  • Wednesday – Astronomers discovered seven earth-sized planets orbiting a dwarf star 40 light years away, which is relatively close in cosmic terms. The planets are in the unique position to harbor liquid water, and potentially life
  • Wednesday – The U.S. Federal Reserve released its latest minutes, indicating they could raise rates “fairly soon
  • Friday – U.S. new home sales increased 3.7% in January, which was less than expected

Our take:
The market didn’t react much following the latest Fed minutes, which presented a more aggressive tone regarding upcoming rate hikes. The language suggested a hike could come as early as March, with expectations unchanged for a three-quarter percentage point increase in 2017. And to no surprise, this has caused a common question to resurface: should bonds remain part of investors’ long-term portfolio allocations?

As we’ve said before, we believe they should. It is true bonds are inversely correlated to interest rates, so as rates rise, bond prices fall (and vice versa). This has driven many to believe bonds are toxic, and investors are better off staying in cash when faced with a potential rising rate environment, such as now. But the extent of this relationship is often misunderstood.

Let’s use a simplistic example with a hypothetical bond ETF. It has a moderate duration of 5 years and a yield of 2%. This means if interest rates rise by a full percentage point, one would expect the price of the bond ETF to fall by 5%, all other things constant. But the ETF still has its 2% yield, which would make up for a sizable portion of the price decline. So on a total return basis the ETF would only lose a few percentage points. Moreover, as the ETF purchases new bonds at prevailing interest rates (in order to maintain its target maturity range), the yield begins to increase. So it would only take another year to almost fully recover from the original price decline (again, keeping all other things constant). And from there the total return would become positive and the ETF’s yield would continue to rise until it reaches market rates.

As such, we believe it is highly likely a diversified mix of bonds with a moderate duration will outperform cash over a multiyear period—even in the face of rising rates. One has to remember that by holding cash you are actually losing money to inflation every year. Moreover, bonds continue to offer valuable downside protection and diversification benefits relative to stocks.

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