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Bonds, Bonds, Bonds!

APCM is expecting reflationary economic policies which will change the investing landscape resulting in upward pressure on economic growth, inflation and interest rates (bond prices to fall) over the next couple of years. This leaves investors asking: Is there still a place for bonds in an asset allocation portfolio or municipal bonds in a taxable account? What does the future hold for money market accounts that contain short duration bonds?

It is said that bonds provide an insurance policy. When the price of stocks go down the price of bonds go up. In mathematical jargon this is a negative correlation.  Harry Markowitz introduced Modern Portfolio Theory (MPT) in 1952 based on the fundamental framework that an asset’s risk should not be evaluated alone but how it impacts the portfolio’s total risk and return.

One argument made in MPT is an investor can reduce portfolio risk by combining assets that are not perfectly positively correlated. Investors can minimize exposure to an individual asset by holding a diversified portfolio of differing assets.

In the past five years the positive correlation between the S&P 500 and the 10yr Treasury has increased. This positive correlation has been driven by the Federal Reserve’s monetary policy, pushing up asset prices in unison. The diversification benefits of bonds have been muted, however APCM continues to believe there is a role for bonds in many types of investment accounts, even with muted returns in the future brought on by rising interest rates (bond prices fall with interest rates increasing).

As we enter an economic period of a strong labor market, inflation rising towards the Fed’s 2% target, and positive “animal spirits” this will allow the Federal Reserve to act in two ways; raise the Fed Funds and start to shrink it’s balance sheet to get to 2008 pre-crisis levels.

In asset allocation, bonds still give diversification benefits and act as an insurance policy to extreme events (tail risk). No one can predict the path of interest rates or events perfectly. For example, at the beginning of 2016 the market believed that the Fed was going to increase rates providing a path for the 10yr Treasury which started at 2.27% to be on a straight path to 3%. However, the opposite occurred and the 10 year declined to 1.36% on July 8th 2016 before ending the year at 2.45%. There will always be uncertainty and risk in the world that will bring volatility to the markets. Bonds provide protection in uncertain times.

Municipal bonds play an important role in an individual taxable account. Primarily it is a way to achieve a dedicated income stream that is tax exempt. Secondly, municipals historically have lower default rates than corporate bonds. Even when interest rates start to rise, municipal bonds are generally held to maturity, and the probability that the security being sold below par is muted. As we move into the third month of 2017 APCM continues to believe in the value of an allocation to municipal bonds for taxable accounts. The highly anticipated tax cuts will likely take time to implement, and will only soften the impact of the benefits of municipals.

Holding cash has been less than exciting the last five years as the Federal Reserve implemented ZIRP (zero interest rate policy). Cash had been earning close to zero until mid-December 2015 when the Fed raised rates to 0.25%.  Good news! Rising interest rates will help returns/yields in money market funds. Money market funds are short duration investment vehicles allowing the securities inside the fund to mature and be reinvested at higher rates.

There is a role for bonds in all types of accounts. At APCM, we recognize that future returns in long dated bonds going forward will be muted relative to the recent past, but over time they provide an income stream and provide protection during times of uncertainty.

Bill Lierman, CFA®
C
hief Investment Officer, Fixed Income

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