At Burgundy, we believe that the best way to grow wealth over the long run is to own the equity of great businesses. However, we still recommend that many of our clients hold some bonds. With interest rates at record lows around the world, why do we still believe bonds are worth owning?
There are a number of reasons why people might want to hold bonds. Here are five of them:
- To preserve capital: a bond is a form of loan, and generally it represents a legal and contractual obligation of the issuer to pay interest and repay principal to the investor (unlike dividends, which are paid at the discretion of a company’s management and board). At Burgundy, we focus on bonds issued by governments and companies that we believe are creditworthy. We expect that the bonds that we buy on behalf of our clients will pay interest and repay their principal in full over the life of the bond.
- To earn interest: bonds make regular interest payments (usually twice a year) that continue until the bonds mature.
- As part of a portfolio – to even out the returns of the portfolio as a whole: bond prices tend to move up and down by less than stock prices, and they often move in the opposite direction. This means that in the event of a sell-off in stock markets, bonds may be able to counteract some of the decline.
- As part of a portfolio – to provide for rebalancing: a related benefit is that, because bonds and stocks may rise in price at different times, there are opportunities to capture a bit of extra value by rebalancing between them. If stocks rise and bonds fall, then clients can “sell high” from stocks and “buy low” in bonds by rebalancing their portfolio to its target asset mix. Over time, this can add value to a diversified portfolio.
- In the hope of price appreciation: people initially may find it surprising that bond prices rise when interest rates fall. Some investors (or traders) might actually buy bonds primarily because they believe that interest rates will fall over time. While this has worked well over the last decade, at Burgundy we try to avoid investing based on this kind of “top down” forecasting. That said, in the event that interest rates fall further, bond prices could still rise.
Would these points still apply in today’s environment, where interest rates are low and may be more likely to rise than to fall further? Let’s look at them one by one:
- Yes, still applies, although there may be some bumps along the road. If interest rates rise, bond prices can fall, but bonds still preserve capital in the sense that if they are held to maturity, their prices will recover to their original value at issue (unlike stocks, whose value does not have a similar “value at maturity”). In order to take advantage of this, investors must be willing to hold their bond portfolios for enough time for prices to recover, which is why we view bonds as more of a medium-term asset (e.g., suitable for holding periods of 5+ years) rather than a cash substitute.
- Yes, still applies – bonds will still pay interest and this is not affected by rising rates. Currently, the amount of interest paid is low by historical standards, but it is still well above that of cash or money market investments. In the event of rising interest rates, over time the average interest yield of a bond portfolio will rise as new bonds are added to the portfolio at higher yields.
- Yes, still applies – bonds will still be affected by different forces than stocks, so they will still offer the potential to “zig” when stocks “zag.”
- Yes, still applies – rebalancing between stocks and bonds will still lead investors to “buy low and sell high” over time as they rebalance.
Point #5 is the only of the five points that no longer applies if interest rates experience a sustained rise; bonds will no longer offer the extra return that comes from rising prices. Over time, in a flat or rising interest rate environment, buy-and-hold investors should expect to earn a return that is close to the yield to maturity of the bonds in the portfolio, without the added tailwind that falling interest rates have contributed in recent years.
So, an investor who expects flat or rising interest rates might have one less reason to hold bonds – but several other important reasons remain in effect.
At Burgundy, we strive to manage our clients’ assets without undertaking the near-impossible task of predicting the future – so we would not suggest holding bonds based on a forecast of lower rates, but we wouldn’t suggest selling bonds based on fear of rising rates either. We continue to view bonds as playing an important role in balanced portfolios.