Low-Yielding Bonds: What Are They Good For?

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. With bond yields currently meager, many investors are wondering whether to make room for bonds at all in their portfolios. Joining me to discuss that question is Alex Bryan. He's Morningstar's director of passive strategies research in North America.

Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: Alex, let's talk about how we got here. Yields are really low. It's been good for bond prices. But let's talk about some of the factors that have been driving yields down.

Bryan: Well, first of all, the Fed has been cutting rates. It took the federal funds, which is the short-term target rate, down below 2%, which is a bit unprecedented given where we are with unemployment being under 4%. So, the Fed has certainly been a big contributing factor to low rates here. You have low inflation expectations, which has allowed interest rates to stay really low. And then you have low rates in other countries where the ECB and other central banks have cut short-term rates very low. In fact, the ECB cut their short-term rates into negative territory. And that reduces demand for borrowing in the U.S. So, that creates a bit of a substitution effect. And with rates as low as they are, a lot of investors are reaching for yield, dipping into lower-quality bonds. And that depresses the yields of some of those lower-quality bonds. So, all around, it's tough to find attractive-yielding bonds without taking on a lot of risk.

Benz: Let's get to the question that we started with to introduce this video. How should investors approach really low bond yields? I think investors are looking at bond products today and seeing cash yields that in some cases are even better than what bond funds yield. How should they approach that issue and decide whether bonds even have a role in their portfolios?

Bryan: Well, I think it's important to take a step back and understand the role that bonds have historically played in a portfolio and the role that I think they should continue to play, and that is to provide a defensive counterweight to stocks, which can help reduce your overall portfolio's risks. So, bonds tend to do well when stocks don't, because they tend to have more stable cash flows. And they tend to do better when interest rates fall, which tends to coincide with a downturn in the economy. So, bonds can help be the ballast in your portfolio when stocks are not doing as well.

Now, with cash yields being competitive, at least with some short-term bond yields, I think it's an open question whether or not you can maybe use cash to play that defensive role in your portfolio. But I would make the point that it's really difficult to know if cash is going to be a better long-term investment than bonds. Historically, that has not been the case. But I would say that if you need the money in the very short term, and you're looking for a guaranteed safety of principal, cash can be an attractive substitute for short-term bonds. But I think bonds still have a role to play. Particularly, if you're a long-term investor and you don't need the money in the near term, I think bonds are probably still a better long-term bet. I mean, if we look back a few years, cash has been competitive with short-term bonds for a while and yet bonds have outperformed cash over the past few years. So, it's really difficult to time exposure between cash and bonds. I think the driving factor here should be: When do you need the money? How risk-averse are you? And let that drive the decision of whether or not you should go into cash or bonds.

Benz: So, one thing you touched on, Alex, in your response is that the cash investor is stuck with that yield basically. That's all you get as a cash investor. Whereas if you are in a bond product, in addition to the yield that flows through to you, you potentially can enjoy some appreciation in bond prices if you have some sort of a bond fund, right?

Bryan: That's right. Yeah. So, bond funds tend to have greater interest-rate risk, just given the fact that a lot of the bonds in the portfolio don't mature right away. And that actually--while that may sound like a risky thing to have, in the context of a portfolio, interest-rate risk tends to pay off when the economy doesn't do very well because that's typically when the Fed cuts rates and when rates tend to fall. Falling rates lead to higher bond prices, which can provide capital appreciation in the bond part of your portfolio. At the same time, stocks may be struggling. So, it's not necessarily a bad thing to have greater sensitivity to interest rates with the bond portion of your portfolio. So, you can get more upside potential with bonds than you can with cash, but you do have that additional risk.

Benz: So, let's discuss how investors can find their way to the right bond products for them, assuming that they want to carve out some kind of a bond allocation. How should they begin to sort among the choices?

Bryan: Well, I think the most important thing is that you shouldn't let a yield target determine how much risk to take with your bond portfolio. Your comfort with losses and ability to absorb them should be the main driver of how much risk you take with the bond portfolio that you have. Your goals will also influence what type of bond solution is appropriate for you. So, if your main goal is to diversify stock risk or keep money in a safe place that you may need in a couple of years, it may be prudent to focus on more-conservative bond portfolios that invest in higher-quality bonds. If your goal is to maximize risk-adjusted performance for money that you don't need for a long time, it may be appropriate to take on a little bit more risk to earn higher returns over the long term. So, really, it's a personal decision about what your risk tolerance is and what your goals for your bond portfolio are.

Benz: Let's also discuss the role of costs in terms of deciding what sort of bond product to gravitate toward. Discuss the interplay between costs and risk in these bond portfolios because they're really tightly connected, right?

Bryan: Well, they absolutely can be. So, when you're in a low-rate environment, as we are today, fees are even more important than they normally are. And they are always important. But with yields being as low as they are, it's very difficult for managers who are charging high fees to recoup those fees. So, oftentimes, managers who are charging higher fees will tend to take on more risk to recoup those fees. Now, sometimes that pays off, but sometimes it doesn't. And that risk is always there. So, it's important to pay close attention to fees not only because it's one of the best predictors of performance but also because managers that are charging high fees might be tempted to take on more risk in order to recoup the fees that they're charging.