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Should You Be Worried About Your Bonds?

investing risk management bonds

 

You are most likely familiar with the old adage "sell in May and go away" warning investors to sell their stock holdings in May in order to avoid a seasonal decline in equity markets. While this approach to stock investing is not a prudent method to enhance your long-term stock performance, does this adage now apply to your bond holdings? As bond prices have begun to fall after a 36-year bull market, now is a good time for investors to review their bond holdings.Cartoon Stock Image

There are certain types of bonds that we, at McKinley Carter, think work in the current environment and other types of bonds that don't. That's why we think it’s important for fixed income investors to evaluate their bond holdings from time to time, to make sure their current bond allocations make sense relative to the interest rate environment and also make sense relative to the risk profile of the company or entity issuing the debt.

There are two types of bonds in particular that have somewhat of a shaky outlook, in our view, and may actually fit into the "sell in May and go away" mantra. They are longer-dated U.S. Treasuries and some high yield corporate bonds.

High Yield Bonds

Let’s start with high yield corporate bonds. In total, U.S. corporations have amassed some $8.8 trillion in total outstanding debt, which marks a 49% increase since the Great Recession ended in 2009. One of the main reasons debt has ballooned so much is that global interest rates have been kept low by central banks around the world, and yield-hungry investors have looked increasingly to the corporate bond market for fixed income.

In some cases, this influx of new issuance has been positive. Small and mid-sized companies that previously had difficulty accessing debt markets could now raise money at better-than-reasonable rates, allowing for more risk-taking and innovation in the economy. For stock market investors, some corporations used the attractive debt markets to borrow money to buy back shares and increase dividends, both of which typically add to shareholder value.

But then there are the not-so-positive cases, where corporations use borrowed money as a band-aid to sustain a failing business model, or to give the appearance of increasing shareholder value in the short-term with no longer-term plan for investment and growth. That's why since 2009, the level of global non-financial companies rated as speculative (junk bonds) has surged by 58%, to the highest ever, with 40% rated B1 or lower.

Long-term Treasury Bonds

On the opposite side of the risk spectrum from high yield corporate bonds, you find long-term U.S. Treasuries, which are challenged because of the current rising rate environment. In the month of May, both the 10-year and 30-year U.S. Treasuries crossed over the 3% mark, though yields plummeted in the final days on fears of Italy disrupting the Eurozone. The uptick of the yield past 3% seems, in our view, inevitable given the Federal Reserve's gradual path of interest rate increases coupled with a U.S. economy at full employment and with the effects of the tax cut just working their way through. As the economy continues to grow with a tight labor market and no slack, inflation pressures should take hold, driving yields up even further.

For investors holding longer-dated U.S. Treasuries, such an outcome isn't exactly ideal - as bond yields rise, the prices of bonds fall, which can show up as a negative return in the near term for bond investors. Of course, bonds held to maturity would typically pay the interest rate as advertised, but there are fewer investors out there who are actually holding bonds to maturity. These days, bond exposure is gotten through ETFs or mutual funds. All the more reason to re-evaluate your bond holdings today to ensure they align with your objectives.

This is key to our approach at McKinley Carter where we target higher quality, short-to-intermediate-term bonds for our clients who hold mostly stocks and a more diversified bond portfolio for clients who own mostly bonds. We view our bond portfolios in stock-oriented accounts as “insurance policies” against a large drop in the stock market brought about by fears of a slowing economy. Higher quality bonds, such as U.S. Government-related, tend to rise in value as stock market investors flock to safer investments in a period of economic uncertainty. For our clients who own mostly bonds, we use a more diversified approach where high yield bonds play a greater role.

Bottom Line for Investors

In the high yield bond world, the current default rate is just 3% for speculative-grade credit, but that has been with the backdrop of a healthy and growing U.S. economy. Should the tables turn or growth slow, there could be a massive unwinding and waves of defaults. Investors should look carefully at the risk profile of their fixed income holdings, as strong investor demand for higher yields in recent years has allowed weak issuers to avoid default by refinancing maturing debt.  At McKinley Carter, we believe that investors must understand the role of bonds in their portfolios.  For “stock-centric” portfolios where the stock exposure drives the total return, we believe that high quality, short-to-intermediate-term bonds are most appropriate as they hedge stock market risk.  For “bond-centric” portfolios (such as 20/80 or 0/100 stocks-to-bonds), we prefer to broadly invest the portfolio across many different types of bonds to spread risk and enhance income opportunities. In the current rising rate environment, we own bonds that are shorter in maturity than the standard bond market indexes as those types of bonds are less susceptible to sharp price drops than longer-dated ones.

We invite you to contact a McKinley Carter Financial Strategist to discuss how bonds may play a role in your overall investment allocations.

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