The cover of this week’s Barron’s reads “Trouble Ahead for Bond Funds.” It refers to an article discussing the downside of holding bond funds in the current environment. Specifically, the article discusses the risk of a decline in prices should interest rates rise.
Someone reading just the approximate first half of the article may think they should completely abandon bond funds. After all, there is validity in the warning. When interest rates finally do rise, the value of the bonds held by these funds will decline. Should interest rates stay fairly stable for longer than expected, then the returns will be lackluster due to the low level of yields.
This doesn’t sound like a very good choice, but the role of bond funds in the current environment should not be to realize decent returns. Rather, bond funds should be used to provide diversification. Holding bond funds can offset the volatility of stocks and allow you to sleep at night. Even Barron’s makes this argument deep into the article.
Consider the likelihood of a 20% drop in stock prices, which is considered to be a bear market. There have been 12 bear markets since World War II. Though there is no expiration date on the current six-year-old bull market, at some unknown point in the future the S&P 500 will have a drop of this magnitude. It’s simply something that is part of the normal return cycle for stocks. For a high-quality bond fund to fall by 20%, interest rates have to jump. The magnitude of the jump depends on interest rate sensitivity of the bond fund, but for an intermediate-term bond fund, interest rates would have to rise by about four percentage points. Nothing Fed Chair Janet Yellen said in yesterday’s or today’s testimony suggested a big enough change in monetary policy in the foreseeable future to move interest rates to that extent.
The four-percentage-point interest rate move is based on a measure known as duration. For each year of duration a bond fund (or a portfolio) has, it will lose 1% of its value for each full percentage point increase in interest rates. So an intermediate-term bond fund with a duration of five years will lose 5% of its value if, say, interest rates rise from 2% to 3%. There are, of course, other factors at play, including credit quality, bond liquidity, expectations for future monetary policy and the overall risk tolerance of investors. All of these factors can influence a bond fund’s actual value. Plus, as interest rates rise, so may the fund’s distributions—assuming the fund manager adjusts the portfolio to hold bonds with bigger coupons (interest payments).
A stock fund’s value can also be impacted by various factors. But over time, stock funds are more volatile than bond funds. The average large-cap stock fund tracked in our Quarterly Low Load Mutual Fund Update had a total risk index of 1.06 at the end of the second-quarter. The average intermediate-term government bond fund had a total risk index of 0.32 and the average long-term general bond fund had a total risk index of 0.63.
These numbers show why holding bond funds in the current environment still makes sense for those who have been previously unnerved by downward volatility in stock prices. Bond funds can provide some stability to an overall portfolio and help to calm your nerves enough so you don’t abandon your long-term allocation strategy.
- Should You Maintain an Allocation to Bonds When Current Rates Are Low? – During past periods of rising interest rates, a diversified portfolio holding bonds still rose in value.
- AAII Asset Allocation Models – Our asset allocation models not only give suggestions, but also show the amount of volatility and downside an investor should anticipate.
- Why Do You Hold Bond Funds? – Tell us on the AAII.com Discussion Boards.
There are no changes to the Model Shadow Stock Portfolio this month. Twenty-two stocks passed the screen at the end of June.
Six stocks in the portfolio qualified for purchase at the end of June: L.S. Starrett Co. (SCX), Salem Media Group Inc. (SALM), SigmaTron International (SGMA), Ultra Clean Holdings Inc. (UCTT), Universal Stainless & Alloy Products (USAP) and Willis Lease Finance Corp. (WLFC). Qualified stocks are companies held within the Model Shadow Stock Portfolio that currently meet the purchase rules. (They are designated as “qualified” in the notes column of the Model Shadow Stock Portfolio table.) Among that group Ultra Clean Holdings was the only new addition in June 2015.
The Model Fund Portfolio was down in June by 2.1%, while the Model Shadow Stock Portfolio, which invests in micro-cap value stocks, was up 2.4%.
The Model Shadow Stock Portfolio’s 2.4% increase for June beat both of its comparison benchmarks: The Vanguard Small Cap Index fund (NAESX) declined 0.9% and the DFA US Micro Cap Index fund (DFSCX) gained 1.6% in June. Year to date, the Shadow Stock Portfolio has gained 3.6%, while the NAESX is up 4.1% and the DFSCX is up 4.2% over the same time period. Since its inception in 1993, the Model Shadow Stock Portfolio has a compound annual average return of 16.7%, while the Vanguard Total Stock Market Index fund (VTSMX) has gained 9.3% annually over the same period.
The Model Fund Portfolio’s 2.1% decline in June compared to a 1.7% decline for the Vanguard Total Stock Market Index fund. Since its inception in June of 2003, the Model Fund Portfolio has a compound annual average return of 9.0%, slightly trailing the Vanguard Total Stock Market Index fund over the same time period, which has gained 9.3%.
More than 130 members of the S&P 500 will report earnings next week. Included in this group are several Dow Jones industrial average components: International Business Machine (IBM) on Monday; Apple (AAPL), Microsoft Corp. (MSFT), Travelers Companies (TRV), United Technologies Corp. (UTX) and Verizon Communications (VZ) on Tuesday; American Express Company (AXP), Boeing Co. (BA) and The Coca-Cola Company (KO) on Wednesday; and 3M Companies (MMM), Caterpillar (CAT), McDonald's Corp. (MCD) and Visa (V) on Thursday.
There isn’t much on the economic calendar. The first report of note won’t be released until Wednesday: June existing home sales. Friday will feature June new home sales and the July PMI manufacturing flash.
The Treasury Department will auction $15 billion of inflation-protected securities on Thursday.
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- Being a Contrarian Means Thinking Differently
Bullish sentiment rose above 30% for just the second time since April in the latest AAII Sentiment Survey. The rebound occurred as bearish sentiment fell for a second consecutive week. Neutral sentiment, meanwhile, tied a 27-year record for the most consecutive weeks of staying at or above 40%.
Bullish sentiment, expectations that stock prices will rise over the next six months, rose 2.9 percentage points to 30.8%. The rebound puts optimism up into the lower level of its typical range. Even with the increase, bullish sentiment remains below its historical average of 39.0% for a 19th consecutive week.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose 3.0 percentage points to 45.9%. The increase keeps neutral sentiment above its historical average of 31.0% for the 28th consecutive week and at an unusually high level for a 15th consecutive week.
Bearish sentiment, expectations that stock prices will fall over the next six months, fell by 5.9 percentage points to 23.2%. This was the second consecutive weekly decline of 5.9 percentage points. The historical average is 30.0%.
Pessimism has declined by a cumulative 11.8 percentage points since hitting a 2015 high of 35.1% on July 1, 2015. Over the same period, optimism has risen by 8.2 percentage points. The moves have occurred as the S&P 500 has established a near-term bottom and subsequently rebounded.
As noted above, this is the 15th consecutive week with a neutral sentiment reading above 40%. This ties a record set between November 13, 1987, and March 4, 1988, for consecutive weeks where neutral sentiment is at or above 40%. Unusually high readings of neutral sentiment (currently above 39.6%) have been associated with better-than-average returns for the S&P 500. For more information, see my May 21 AAII Investor Update, Unusually High Neutral Sentiment Often Followed by Good Returns. (There is no guarantee, however, that history will repeat.)
Keeping some AAII members optimistic is the Federal Reserve’s still-accommodative monetary policy, the ongoing bull market, sustained economic expansion and earnings growth. Causing some AAII members to be cautious are concerns about the possibility of a bigger decline in stock prices occurring, the pace of economic growth, the lack of wage growth, valuations, the impact of the stronger dollar on earnings and geopolitical events.
This week’s special question asked AAII members whether, and why or why not, their short-term outlook for U.S. stocks was affected by the recent drop in Chinese stocks. Nearly three-fourths (74%) of all respondents said the June/early July drops in the Shanghai and Shenzhen exchanges have not impacted their short-term expectations for how U.S. stocks will perform. Reasons given were mixed, though many said they do not invest in Chinese stocks, they view the Chinese markets as having a low correlation with the U.S. markets or that Chinese stocks had a big upward run before the recent plunge. Others simply said that they follow a long-term investment strategy.
About 18% of respondents said they are more cautious about U.S. stocks following the price drop in Chinese stocks. Their concerns include a slowing of U.S. economic growth caused by China and the potential for a negative, spillover effect on U.S. stock markets.
Here is a sampling of the responses:
- “Chinese stocks have risen so much, it’s not surprising that they would take a few steps backwards at some point.”
- “I’m not a short-term outlook type of guy. I prefer to stay the course, barring disasters.”
- “I refuse to invest in China due to the political influence of the Chinese government.”
- “It seems that over the long term, U.S. stocks react more profoundly to domestic economic news.”
- “The Chinese slowdown will have a negative impact due to the number of U.S. companies that do significant business in China.”
Bullish: 30.8%, up 2.9 points
Neutral: 45.9%, up 3.0 points
Bearish: 23.2%, down 5.9 points
Bullish: 39.0%
Neutral: 31.0%
Bearish: 30.0%
Local Chapter Meetings
July 9, 2015 Historical Similarities Are Not Guides for China and Greece
July 2, 2015 My Notes From the Morningstar Investment Conference
June 25, 2015 I’m Creating a New Stock Strategy
June 18, 2015 401(K) Plan Outflows Exceed Contributions as Baby Boomers Retire
