Why Bonds? Part 2

As a “bond guy,” it is not unexpected that I am a fan of the positive attributes that bonds can bring to a portfolio. Things like regular cash flow, the ability to “dial-in” the amount of interest rate and credit risk, and negative correlations to equities all lead to a good portfolio component.  This thought process has worked out very well on a year-to-date basis (see previous blog post here for more info:  https://www.dattilioash.com/our-blog/2019/8/7/why-own-bond-funds). 

During my years managing interest rate risk at a major insurance company, we had sophisticated systems and analytics to measure and manage our fixed income portfolios and exposures along the yield curve.  The math was sound and proven to provide useful information that we could use to manage exposures.  The trouble, however, was that we were not very good at forecasting interest rates!  The best we could do was manage our exposures; trying to position for a rate spike or yield curve flattening or steepening to pick off some extra total return almost always ended in a losing proposition.  Consequently, we resigned ourselves to manage a “matched” book; making sure that our asset and liability durations were matched within a tolerance range to “immunize” our target return.    

I feel the same way today.  Running an “immunized” fixed income portfolio to its liability target is exactly analogous to managing a “long term strategic asset allocation” to a target risk profile.  Some of my peers in the industry took confident positions in “short bond ladders” and “short government agency paper” to position for rates to rise due to the consensus view for 2019.  They were all dead wrong (so far) and missed the excess returns provided by taking duration and credit risk from other fixed income sectors. 

Certainly, rates could go lower from here or stay the same for a protracted period of time; especially if the global trade tensions lead to a U.S. (and global) recession.  In that case, bonds could produce positive total return above current yield rates (10-year treasury yield of 1.64% as of today, for example).  Alternatively, rates could go higher if the U.S. Fed and global central banks are (ever) successful in promoting more robust growth and inflation above meager sub-2% levels.  Of course, rates are ALWAYS subject to ups and downs; we just don’t really know when they will emerge.

Please see my prior blog post from June 2019 to see more detail on interest rate forecast foibles: https://www.dattilioash.com/our-blog/2019/6/13/interest-rate-forecast-foible