Many bond investors are growing tired of low returns, the endless warnings that rates are about to rise, and constant reminders of the dangers of riskier bonds. None of us have ever lived through this kind of extreme, long-lasting suppressed rate environment. One result is an investor who is frustrated and willing to take on significant risk to get an incremental improvement in yield.
Everyone has seen the pain tolerance charts in doctors’ offices. Doctors use it as part of their evaluation process to detect patient’s levels of discomfort. Investment advisers do the same for their clients in the form of an investment questionnaire: What is your tolerance for portfolio losses? What is your preference for trade-offs between risk and return? Investors may believe they face an unenviable choice: accept the seemingly unending background pain of low yields or take the plunge and give those long, low-quality bonds a go and worry about the potential pain of major losses later.
“We must all suffer one of two things: the pain of discipline or the pain of regret or disappointment.” – Jim Rhon
Prospects for higher returns can be accompanied by the potential for larger swings in market value (i.e., portfolio volatility). Translating Rhon’s famous quote to investing addresses the constant struggle between greed and fear. Typically, when markets are moving higher, most investors turn greedy and want more. Should an investor’s more conservatively positioned portfolio produce lower returns when the market surges, the investor may regret not having taken more risk. In contrast, should a riskier portfolio drop significantly in market value the opposite may happen and an investor may begin to regret their decision to have invested in risker assets. This can be accompanied by a fearful overreaction.
Ideally, investors maintain a mix of assets they believe appropriate for their situation. This is important because, as Ibbotson and Kaplan conclude in a 2000 study, asset allocation explains about 90% of the variability in returns over time. Bonds are usually included in investor portfolios because they may help to reduce the likelihood of extreme swings in market value. But not all bonds are made alike. As we learned in 2008, lower quality and higher beta bonds can drop in value precipitously.
Investors who are compelled to chase higher yields in search of incremental return may be exposing themselves to unforeseen risk. As Rhon’s quote implies, we believe successful investors “win” over the long-term by committing to a disciplined approach. This may mean accepting short-term discomfort for long-term security.
Keep in mind most investors’ view their bond portfolios as their anchor and desire low volatility. This benefit comes with the likelihood that returns may be muted at times. Importantly, most investors do not want to lose principal. Given today’s market environment, we question why an investor might choose to raise risk in their bond portfolios by investing in longer maturity bonds and/or lower quality securities. Instead, investors have what the industry calls “risk assets,” such as stocks, which we believe may add or reduce portfolio risk more efficiently and sensibly by moderating allocations.
Madison believes a bit of prevention (e.g., defensive fixed income positioning) may lessen the likelihood of experiencing truly unnecessary pain.