The overlooked bond factor that will matter in a bear market

Because of the volatility and routs that rocked the financial markets late last year, investors have entered 2019 with an appetite for defense and haven assets. That includes increasing their fixed-income allocations with more bonds in their portfolios.

But investors who go down that path may be overlooking one critical factor. “People often come to me with the firm belief that they have safe bonds or bond funds,” wrote Allan Roth, founder of US-based financial-planning firm Wealth Logic, in a piece in the Wall Street Journal. “In the vast majority of cases, however, they are producing just a little extra income while taking on a ton more risk.”

Roth argued that investors and investment advisors assume that bonds are conservative, taking the credit quality of a given bond for granted. That means when stock markets and economies plummet, those who take on lower-quality bonds are likely to get blindsided by higher default rates and lower liquidity.

“In 2008, the S&P 500-stock index lost 37%, including the dividends paid,” Roth said, recalling the previous decade’s defining financial crisis. “Before it was all over, U.S. stocks lost nearly 55% of their value.”

That time, he said, was especially agonizing for those incorrectly thought that their bond investments would absorb the shock.  For those who invested in a true high-quality bond fund, the pain from stocks was mitigated a little with a gain of nearly 8%, according to Morningstar. But because most investment-grade bonds declined and high-yield bond funds lost almost as much as stocks, the average bond fund lost some 8% that year.

“People lost money trying to earn a little extra income,” Roth said, highlighting the perils of taking on outsized risk with bonds. He added his prescriptions for high-quality bond index funds often meet with pushback from investors, who argue that the 2008 scenario will not happen again and that his bond recommendation has lagged most of its peers over many years.

“Those other bond funds took on more credit risk, something that works when stocks do well.  And 2018 marked the longest bull stock market in history,” he noted. “The recent past, however, hasn’t been so kind to stocks.”

As history appears to be repeating itself, he left several reminders for investors:

• Take risks with stocks rather than bonds;
• For US fixed-income investors, at least half of their bond or bond-fund exposures should be backed by the US government or a US government agency (“Most investment-grade taxable debt is issued by the US government”);
• Remember that the purpose of fixed income isn’t actually income, but to be the stable portion of the portfolio that can be rebalanced and used to live on in retirement; and
• Always keep costs low, as the extra risks taken by bond managers to beat the market may not be worth it.

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