Nearly all of Mercer Advisors endowment and foundation clients maintain bonds (fixed income) as an integral part of their investment portfolios. Bonds are considered an important asset for achieving diversification. Recently, clients have wanted to understand why bond exchange-traded funds (ETFs) in their portfolio have fluctuated in share price. They’ve also asked whether bonds still make sense in a portfolio today, and whether they’re riskier than stocks. While the media certainly emphasizes the perceived risk, we believe fixed income remains an important component for most portfolios in the nonprofit sector. Here’s why:
Price vs. yield
Much of the share-price fluctuation of an individual bond, bond ETF, or bond mutual fund can be attributed to the inverse relationship between yield and price. As interest rates go up, prices go down (the opposite is also true: if interest rates go down, prices go up). If you’ve invested in an individual bond that yields 5%, for example, and new bonds are coming to market yielding 7%, the price of your bond must be lowered so that it’s attractive to buy. Imagine a seesaw on a playground, with interest rate on one side and price on the other.
If you have no plans to sell the bond, this becomes inconsequential—you simply hold on to the bond until maturity. Once the bond matures, you can reinvest for the yields current at that time, which is exactly what most bond funds do.
Bond ETF example
Vanguard Short-Term Bond ETF (BSV) is an investment vehicle that’s in some client portfolios. This fund has over 2,500 different bonds that mature on a regular basis. As they do, they’re replaced by new bonds available in the market. Essentially, the ETF functions like a perpetual diversified bond ladder, which is a portfolio of individual bonds that have staggered maturities. The ETF is professionally managed by Vanguard Fixed Income Group, with over $57 billion in assets in this one fund. Vanguard can purchase bonds in mass (much more than a nonprofit could on its own) and pass on the savings to shareholders of the fund.
Another important consideration is the concept of total return, which is yield plus or minus the bond or share price. With bonds, over 90% of the potential return comes from the dividend, and the dividend is always positive.
Here’s a snapshot of recent BSV performance to illustrate total return:
| Year | Capital return by NAV | Income return by NAV | Total return by NAV |
| 2022 | -6.90% | 1.35% | -5.55% |
| 2021 | -2.15% | 1.14% | -1.00% |
| 2020 | 2.81% | 1.86% | 4.67% |
| 2019 | 2.53% | 2.39% | 4.92% |
| 2018 | -0.67% | 2.01% | 1.34% |
| 2017 | -0.44% | 1.64% | 1.20% |
| 2016 | -0.05% | 1.47% | 1.42% |
| 2015 | -0.38% | 1.30% | 0.92% |
| 2014 | 0.12% | 1.20% | 1.32% |
| 2013 | -1.00% | 1.18% | 0.17% |
| 2012 | 0.48% | 1.55% | 2.02% |
Source: Vanguard
In 2022, the U.S. bond market had its largest and fastest increase in interest rates in the past 100 years. As a result, the capital return (price) of the bond ETF decreased by 6.9%. The income return (yield) remained positive, however: 1.35%. This was the worst year on record for BSV total return, down only 5.5%. By comparison, stocks can be down 5.5% in an instant and no one will blink.
Key takeaways
While every foundation and endowment has its unique needs, goals, and risk tolerance, bonds should not be overlooked in a diversified investment strategy. In short:
- The market value of a bond is always fluctuating, based on current interest rate.
- Bond returns are more likely stable than stock returns because more is known about their future income flow.
- The best predictor of a bond portfolio’s future potential returns is the current yield; as illustrated, nearly 90% of a bond’s potential return comes from the yield.
Bonds (or bond ETFs and bond mutual funds) often make sense for a nonprofit organization because of their positive yield and the diversification they bring to a larger portfolio. Working closely with an investment advisor to determine the appropriate mix of stocks and bonds is key to ensuring that your portfolio is aligned with your investment goals, objectives, and risk tolerance.
