Fixed income is often described as the bedrock of a portfolio. Today, it seems that bedrock is actually an iceberg of melting ice. Over the years, we have written extensively on the role of fixed income in your portfolio, and mostly recently in the Summer issues of 2015 and 2016. These can be found in the Bond section of InvestorU in our Foresight Library. As we have prepared Annual Reports over the summer, we have arrived at the future that we wrote about earlier: current annual bond returns recently have fallen to….zero!
When a portfolio with an asset allocation plan of 50% bonds/50% equities has the bond portion returning near 0%, equities must return 10% for the portfolio overall to have a 5% return. A 10% equity return is greater than long term averages historically, meaning that a 10% year is an over-performing year.
Before we panic, we need greater understanding about bonds. When we first buy a bond, we lock in some rate of return for the entire holding period until it matures. During that holding period, the market place prices that bond to reflect what is going on in the economy along the way. As a result, the bond’s return in each holding year will fluctuate accordingly. The following chart shows the annual return history up to July 31, 2017 for a provincial strip bond bought for $49,677 in 2008 to yield 4.78% to maturity in June 2017:
Several things are notable here. First, the line of annual returns (“Bond%) across that decade: they fluctuate from .75% to 9.41%. Also, the years 2010-12 each show annual returns far above the maturity yield of 4.78%. Oddly, no year along this row produced a return close to the 4.78% guaranteed yield. Second, the sum of the gain/loss row across the 10 years precisely totals zero – which is correct. This means that the return over the 10 years is precisely the sum of the interest row, and totals $28,323. Third, the bottom row is the overall portfolio return achieved in each of these years. By comparing the bottom two rows, we get a sense of how the bond portfolio contributed each year vis-à-vis the equity component. (this portfolio has a high 70% bond allocation). For instance, in 2013, the bond returned only 1.93% but the overall return was 7.49%, meaning that it was a great year in the stock market. Lastly, we see that the annual returns of this bond for 2013 to maturity in 2017 were all low (counteracting the big years 2010-12). This one bond, as a micro example, is indicative of the whole macro bond scene.
So, where does this leave us… loving or hating our “safe” bond portfolio? We believe the former. Why? First of all, bonds have three roles in a portfolio: provision of income, diversification to the volatility of stocks and cash flow from maturing principal so that we never have to sell stocks at an inopportune time to meet your cash needs. Bonds today are not providing a great deal of income, however they continue to serve the other two purposes. Second, the contribution to portfolio return from the bond portfolio needs to focus on the yield to maturity, not the current year yield (we report both to you in your Annual Report) because this is the return you actually get from the bond from start to finish. Lastly, it is the overall portfolio return that matters. During those last five years of poor bond returns 2013-17 in the chart, this particular portfolio, with 70% bonds, had an annual five year compound return of 6.15%. The high years 2008-12 saw lower overall returns, meaning a cooler stock market. The asset allocation model called us then to buy stocks…low. A beautiful thing!