These are hypothetical scenarios that do not represent the performance of Silver Bridge or any actual investment portfolio.
Furthermore, an examination of just the ending market values at year five demonstrates that the short and intermediate bond portfolios are almost fully restored to their initial level after an interest rate cycle, and even the long bond portfolio comes back (save for $5,000). Considering how difficult it is to perfectly predict interest rate cycles, the best strategy would seem to be one in which an investor holds bonds in appropriate allocations permanently, but with tweaks at the margins to position the portfolio for downside protection or upside momentum as his or her judgment warrants.
On the subject of those tweaks, it is important to remember that the term structure of interest rates does not move up and down in perfect parallel shifts, and all bonds are not correlated one-to-one with Treasurys. The shape of the yield curve is dynamic, and can invert, steepen, flatten or shift by varying amounts depending on the economic environment, the interest rate policy and inflation expectations.
An active bond manager attempts to anticipate these movements of the yield curve and position portfolio maturities accordingly to protect against or limit negative price movements. Furthermore, Treasury bonds, as the rawest expression of interest rate risk, can be minimized as a holding in rising interest rate environments in favor of spread sector securities such as corporate bonds, whose incremental income advantage helps diminish losses, particularly if spread compression opportunities exist.
Also, bonds nowadays come in many different varieties, with fixed, floating or step-up coupon rate structures; with one-time or multiple call and put features; or with inflation protection, if that is a concern. These options allow professional bond managers to soften the pain of interest rate risk, and help bonds deliver long-term value within an investor's asset scheme.
Less Volatile
Bonds still have the lowest historical volatility of any asset class other than cash-the historical volatility of fixed income is 3.5% or less, which cannot be said of domestic equities, international equities (or bonds), commodities, real estate or even hedge funds. Despite the rising popularity of absolute return hedge fund strategies touted for their combination of equity-like returns and bond-like stability, there was never a better demonstration than the one in 2008 that bonds are sleep-at-night money.
Furthermore, bonds are the go-to investment when investors flee to quality. They were an excellent investment from 2000 to 2002 when the equity markets fell both before and after the September 11 attacks, and again more recently at the height of the credit crisis. For most clients, bonds play an important role stabilizing their portfolio structures, and clients appreciate them for their low volatility, their liquidity and the better income advantage they have over other asset classes.
Interim Price Less Concerning
Bonds held to maturity are unaffected by interim price swings.
If appropriate diversification can be achieved, clients may want to consider using a portfolio of individual bonds for their fixed-income allocation, given the advantage they have over bond mutual funds in a rising-rate environment. While there are many excellent fund offerings run by dynamic and skillful investment managers in the fixed-income space, the fact remains that bond mutual funds do not have a specified maturity date with a guaranteed return of principal. They trade at net asset value, and are subject to the whims of their shareholders-and unfortunately, these investors have shown in the past they are willing to head for the door when rates start rising, forcing even the most skillful manager to sell holdings and lock in losses at the most inopportune times.
Meanwhile, 60% to 80% of the holdings in an individual bond portfolio are likely to be held to maturity, which means an investor recovers principal in full (assuming there are no defaults). No matter what kind of roller-coaster ride interest rates take during the life of a bond, its value will always be par when it is redeemed.