Your Income Generating Investments Are Going To Get Better
Key Takeaways
The last two years of bond underperformance have affected conservative investors more than aggressive ones — however, bonds continue to offer diversification benefits, and at the moment, good yields.
While higher rates negatively affect bond prices initially, long-term investors stand to benefit by reinvesting and compounding at higher yields in the future.
Those relying on their investment portfolio for income generation should focus on the total return of their bond component instead of just prices alone. We are approaching a point where the bond pain is going to turn into a gain.
If you don’t find a way to make money while you sleep, you will work until the day you die.
— Warren Buffett
Volatility and paper losses in the bond markets caused primarily by the quick interest rate hiking cycle has affected conservative investors more than aggressive ones. With 2022 being one of the worst years for bond investors and 2023 faring only a little bit better, this leaves investors with concerns — especially those who might be nearing or already in retirement, and are naturally more heavily invested in fixed income.
However, the concept of portfolio allocation has not changed despite these lacklustre years. Bonds continue to offer benefits in portfolios, and at this juncture, are set to offer great value due to what has happened over the past two years. Not only do bonds continue to offer diversification benefits, bonds now offer good yields — yields that have not been seen since the 2008 financial crisis. Investors who are currently reassessing their exposure to bonds due to recent losses should pause for a moment as the benefit of higher rates to their portfolios is about to materialise.
The return you get from bonds comes from price return and coupons or income return. When interest rates change, the two components tend to move in opposite directions. While higher rates may negatively affect bond prices initially, long-term investors stand to benefit by reinvesting and compounding at higher yields in the future.
The illustration below shows what happened last year in 2022 — we had a low starting yield for bonds as interest rates were low. However, as rates rose, bond prices decreased significantly.
For this year, as rate hikes continued albeit at a lesser pace, bond prices also continued to come down but at lesser levels compared to 2022. The starting yield for bonds was also higher.
From here onwards, this is where it gets better. With yields at their highest levels in a long time, bonds today can offer more significant value in total returns to a portfolio. Given the likelihood that many central banks are near the end of the hiking cycle, and inflation continues to come down from elevated levels, this provides support for asset prices. The current high bond yields help to compensate for last year's capital losses, and over the next few years, the cumulative total return should become positive.
Rate hikes have also brought cash deposit rates to levels not seen in a long time. Whilst holding cash is necessary from a financial planning perspective, holding too much can result in a large opportunity cost. Using the 3-month U.S. Treasury bill as a proxy for cash and the Bloomberg U.S. Aggregate Bond Index as a proxy for bonds, comparing the returns of both asset classes between January 31, 1978 and September 30, 2023 shows that bonds outperformed cash most of the time, even when rates were high (diagram below).
So, like any investment, patience is key. And investors who are relying on their investment portfolio for income generation should focus on the total return of their bond component, rather than just looking at prices. We are approaching a point where bond pain is going to turn into a gain.
If you would like to know more about the bond components in your portfolio construction, feel free to have a chat with us.
