The past few years have called into question how best to use bonds in a portfolio. Historically, bonds have been viewed as a much-needed anchor for portfolios, providing a counterbalance when stocks become volatile. The classic “60/40” (i.e., a broadly diversified portfolio comprised of 60% equities and 40% bonds) has produced top-tier risk-adjusted returns historically. However, in 2022, the 60/40 produced one of its worst years in history as stocks and bonds tumbled together for the first time in decades. Moreover, 2023 was a lukewarm year for bonds with gyrating interest rates and tightening economic conditions. So, is it time to abandon bonds? We believe that answer is no, for bonds are still an important component of portfolios. The amount, of course, should vary depending on an investor’s risk profile. However, we anticipate that the next decade will be a “bond pickers” market where it will be critically important to manage risk through portfolio construction (i.e., making strategic decisions about bond types and bond maturities).

Let’s first look at why bond maturities matter. Bond professionals refer to a bond portfolio’s interest rate sensitivity as “duration,” which is directly driven by the maturities of the individual bonds in the bond portfolio. In short, duration is a measure of the average time to receive all payments from a bond portfolio. Duration is important because, while longer duration bonds tend to pay higher yields, they are more sensitive to movements in interest rates, and therefore are more volatile. Let’s look at an example. Vanguard offers many exchange-traded funds (“ETFs”) that represent baskets of different types of bonds. The most popular ETFs for corporate bonds are the following:

While all of the above bonds fall into the “corporate bond” sector with similar credit risk characteristics, the durations are radically different. The chart below shows how these ETFs performed during a period of rapidly rising interest rates (i.e., 2022). In such an environment, the long-duration portfolios suffered the most, being down -25.5% while short-duration corporate bonds were down -5.6%. It’s clear from this chart how important it is to understand interest rate movement in building bond portfolios, as the moderate gains in yield did not buffer portfolios from plummeting bond prices.

Beyond duration, it is critical to understand the underlying credit risk of bond portfolios. Turning again to the ETF world, below are three ETFs that have moderate portfolio durations but very different credit risk profiles. For example, U.S. Treasury Bonds are considered the lowest risk bonds in the world. See below where we contrast Treasury bonds with both “investment grade” corporate bonds, that carry some economic risk, and “high yield” bonds which represent significantly higher economic risk.

Generally speaking, bonds with higher credit risks pay higher coupons (as shown above). So, investors may be tempted to “reach for yield” (i.e., buy bonds with the highest paying coupon while underappreciating the risk). Timing is critical for those looking to hold higher-risk bonds as the loss in price can greatly, and rapidly, overcome any moderate gain from higher coupons.  For example, in reviewing the market panic during COVID (12/31/2019 – 3/31/2020), we can see how these higher risk bonds are prone to sudden and significant drawdowns. The bond holding with the most credit risk out of the three listed above, SPDR’s High Yield Bond (JNK) had an intra-quarter drawdown of -24.5% before finishing the quarter -12.7%.

In summary, as interest rates remain at decade highs, we’re excited about the opportunity to deploy bonds in investment portfolios. We think bond price volatility, driven by credit and duration risk, will provide substantial opportunities in the coming years for carefully constructed portfolios.