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What Role Do Bonds Play in an Era of Ultralow Yields?

Investors are right to be questioning bonds' role in their portfolios, but they still serve a useful purpose for many.

Editor's note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Susan Dziubinski: Hi, I'm Susan Dziubinski for Morningstar.com. The COVID-19 crisis has driven down the yields of high-quality bonds, leaving many investors asking themselves, "What role, if any, should bonds be playing in my portfolio today?" Joining me to address that question is Christine Benz. Christine is our director of personal finance at Morningstar.

Christine, thanks for joining us today.

Christine Benz: Susan, great to be here.

Dziubinski: Now, the Fed has cut interest rates to near zero. What are the implications for bond investors? What can they expect from a return perspective?

Benz: Well, it's not good, certainly over the next decade. One thing we know about bonds is that yields are pretty predictive of the return that you'll earn over the subsequent decade. So, with low, very low single-digit yields today, that portends a very low-returning asset class here. And then another thing that you can't help but think about is that even though no one's worried about any sort of imminent interest-rate hikes, given the economic weakness that we're experiencing, rates at this point have much more room to move up than they could move down, and that could affect bond prices. So those are some headwinds for bonds for sure. I think investors are right to be questioning and thinking about their role in their portfolios.

Dziubinski: Yeah, you still do think that bonds can and should play a role in some investor portfolios?

Benz: I do. For younger investors, for people who have a very long time horizon for their funds, they really don't have a need for a big allocation to bonds unless they're extremely risk averse. But the closer you get to your goal date, especially retirement, the more you'd want to think about battening down the hatches with the portion of your portfolio that you expect to spend soon. Because bonds really do still serve that role of shock absorber in investors' portfolios.

A portfolio that was all equity, all U.S. equity would be down about 19% for the year to date, whereas a balanced portfolio, like a 60% stock/40% bond portfolio, would have been down just about 10% for that same period. So, bonds do add ballast, they do help take the edge off in periods when equities are volatile. And I think you can realistically expect that there could be a fair amount of volatility in the days and weeks and even months ahead.

Dziubinski: Your time horizon should play a significant role in the types of bonds that you own, right?

Benz: That's right. And it was interesting because we did see bond prices bop around a little bit during the recent equity market volatility, especially some of the corporate bonds, municipal bonds as well. But I think investors can really help themselves by thinking about their time horizons, their proximity to spend-down and use that to inform what types of bonds to own.

So, if you have money that you need really soon, my advice would be to keep those funds in cash or maybe in very short-term, high-quality bonds. When we look back on the historical performance of high-quality, short-term bonds, what we see is that they have very few one-year periods where they actually end up in the red. So very few 12-month stretches of time where they lose money, and when they do encounter those rough patches, they tend to be pretty shallow, so they can recoup those losses pretty quickly.

I would say if you're a couple of years into the future in terms of spending from those assets, you'd want to think about high-quality, short-term bonds or bond funds. On the other hand, if you have a slightly longer time horizon, say a three- to five- to seven-year horizon, I think there you can think about a high-quality intermediate-term fund, whether a total-bond-market tracker or maybe some sort of an active fund.

When we look at how such funds have performed in market history, they have had more periods, more one-year periods where they've had losses, and those losses have been deeper, which suggests that you wouldn't want to use them for any very near-term expenditures. But if your time horizon is slightly longer, you can afford to take a little bit more risk because you can at least historically pick up a little bit of a higher yield.

Dziubinski: And while we're on the topic of bonds, let's pivot to a related subject: inflation. Why is inflation so important for bond investors to pay attention to?

Benz: Well, it's the natural enemy if you're a bond investor. Because if you think about it, the income you earn from the bond coupon, that's your purchasing power. And when inflation is going up, that eats away at the purchasing power from that bond. So, you want to be really mindful of inflation with respect to your bond holdings. Right now, there is not a lot of concern over inflation. We have a pretty tepid economy or worse. And so I don't think that there's a lot of concern that we're going to see prices take off from here. But over time, it could become a bigger factor. And remember, as a bond investor, if your yields are really low, inflation doesn't have to be that high to eat away at your purchasing power.

Another concern that has been out there, has been the role of some of the stimulus that has been going on to keep the economy moving along. Could that be inflationary down the line? So, my bias is not to get too fancy about adding and subtracting protection from your portfolio, but rather, again, use life stage to guide how much to be worried about it. If you are someone who has a paycheck coming in, so if you're still earning a salary, your paycheck typically is inflation-adjusted in some fashion.

On the other hand, if you're retired, I think there it makes sense to maintain an ongoing allocation to inflation-protected bonds, either some sort of a Treasury inflation-protected bond fund or maybe using I Bonds or maybe a combination of the two, using that as an ongoing hedge against unexpected shocks in terms of inflation. I think that that's a good way to think about maintaining inflation protection on an ongoing basis. That way you're ready for it when and if it materializes.

Dziubinski: So, it sounds like there are still plenty of reasons for us to consider bonds for our portfolios.

Benz: I think so.

Dziubinski: Thank you so much for your time, Christine. We really appreciate it.

Benz: Thank you, Susan.

Dziubinski: I'm Susan Dziubinski for Morningstar.com. Thanks for tuning in.