Episode 42: How to Think About Bonds

Hello, everybody. This is Don Calcagni, Chief Investment Officer with Mercer Advisors. Welcome to this edition of our Market Perspectives podcast.

I’m flying solo today. Unfortunately, my partner, Josh Zumbrun, could not join me today.

But the the topic for today’s conversation is to is to try to explore fixed income, specifically bonds.

And and really to just give you a high level overview of, you know, what’s happening in the bond market, but more importantly, how should we think about bonds in our portfolios on a on a going forward basis. And so just to just to begin, let’s begin with a high level overview of bond returns. And so if we look at bond returns on a year to date basis, and many of you have asked me about this is, you know, gee, Don, you know, bond returns have been negative. Why would we continue to invest in bonds going forward?

So let’s first look at some some facts. So if we look at the Bloomberg Global Aggregate Bond Index, this is a global bond index. It’s lots and lots of bonds from all over the world. That particular index is negative about 0.62

year to date.

So not not horrible, but flat negative. We don’t like negative, and this is coming in a year where we’ve had really good stock market returns. So stock market returns are up, you know, 12 to 13% depending on the day. Mercer stock portfolios are up somewhere around 14 to 16 to 17% depending on the strategy. Now how are we doing with respect to our bond allocations within our portfolios? And as you know, at Mercer Advisors, we run a wide variety of different bond strategies depending on investors’ objectives.

And our traditional bond strategy is negative about 0.3% so far year to date. So doing better than the broader market, the broader bond benchmark by about 0.3%, but still slightly still slightly negative.

So I think we need to just…

You know, that’s kind of where we’re at at the moment. Other bond strategies are positive. You know, we run a tips strategy. Those are treasury inflation protected securities.

Those are positive about 1.8% so far this year. But most bond strategies, to be fair, are slightly negative for the year. And so the question is, well, why?

You know, if the stock market’s doing so well and the economy is growing, why are bond returns negative? And it really comes back to the very simple fact that the bond market, which is millions of participants the world over, the bond market has raised interest rates. So interest rates have risen this year and not by a little, by by quite a bit. And those increases in interest rates really began with the war against Iran in the in the end of February.

And we’ve seen the bond market raise interest rates across the curve, which in English means for all different types of bonds at all different maturities. So a two year bond, a five year bond, a ten year bond, what we’ve observed is interest rates have risen across the curve. And one of the things that is critically important for all investors to keep in mind with respect to bonds is that when when interest rates rise, the price of existing bonds fall. Right?

And it has to be that way. If you have a bond that currently pays 2% and interest rates rise to 5%, nobody wants to buy your bond anymore unless you lower the price such that I’m earning effectively a 5% yield. You have to lower the price on existing bonds in order to give investors the yield that they could earn today on new bonds. Alright?

All things equal. So that’s what’s happening in the bond market. And you may be thinking, well, gee, well, then why are interest rates going up? Well, lots of reasons.

We’ve talked about this on prior podcasts. The the growing federal debt, the $2,000,000,000,000, per year deficit that our federal government continues to accrue. It could also be the fact that we have lots of AI companies coming to market, borrowing significant amount of capital in order to build things like data centers and really build out the AI infrastructure necessary to fuel, to support this new AI powered economy in which we find ourselves. All of these things require require capital and continue to push interest rates up.

So the way I like to think about it is that the demand for capital has risen, but the supply is still largely the same. So anytime you have demand rising and supply held constant, what happens? Prices rise. The interest rate is just the price to borrow capital in a free market.

So that’s what’s happening at the moment. Part of it is necessarily tied to inflation and things like that. So there’s there’s certainly more at work here. So I don’t wanna ignore, you know, things like inflation.

I don’t wanna ignore the geopolitical risks. I think those things are significant as well. But at a high level, I think it comes back to the U. S.

Federal government continuing to borrow substantial amounts of capital, and now you have a significant number of AI companies coming into the market borrowing borrowing substantial amounts of capital.

So that’s why interest rates are rising. As those rates have risen over the course of the year, bond prices have gone down, and that’s why you’re seeing these very slight negative returns on bonds at the moment. Now the question is, well, gee, given these negative returns, what… What’s the investment case for owning bonds going forward? You know, should we perhaps give up on bonds and, and maybe just sit in cash or do something like that? I think the answer to that is objectively no, and and here’s why.

As these interest rates have gone up, quite significantly, the investment case for owning them has actually gotten even stronger. So if you’re deploying capital today, for example, into U.S. government bonds, you’re gonna earn anywhere from in the mid 4 percent range to, you know, five and a quarter percent.

If you look at the Barclays Ag right now, it’s yielding about 5.24%. So interest rates have risen. That’s your income. That’s your return on owning those bond investments.

And so if you were willing to own bonds twelve months ago that were paying three and a half percent and those same bonds today are now paying 5%, I would argue you’d still want to own those bonds. Right? And so the income that we are now earning, I mean, with bonds, you know, bonds are fixed income instruments. That’s why we own them is because they provide that steady stream of cash flows back into our portfolios.

So income has gone up, across the bond market. So for those investors in search of income, for those investors who are also in search of diversification, trying to diversify the equity side of your portfolio, these higher yields make it easier to do that.

In fact, I would argue that the diversification power of bonds is directly tied to interest rates, the interest rates that they pay. The higher the interest rate, the more that that bonds, especially shorter duration and high quality bonds, the more diversifying power they’re gonna have on your portfolio, and they’re gonna be able to buoy. They’re gonna be able to minimize that downside pressure in your portfolio inevitably when equity markets have a bad year. Right?

It’s it’s it’s gonna happen. All of us have been investing for very long periods of time. We’ve had great equity market returns the last few years. We all know that equity markets, stock markets don’t go up every year by double digits.

There’s eventually gonna be some sort of retracement, and that’s where we’re gonna lean on the bonds in the portfolio, especially these these bonds that pay higher yields.

So the investment case for owning bonds, I would argue, has actually strengthened over the past over the past year due in large part to the fact that interest rates have gone up. So you definitely wanna own these in your portfolio in order to help protect against future downside, you know, downside drafts in the market.

So, yes, the the investment case for fixed income, I think, remains exceptionally strong, and you would still want to own those. Right? Sitting in cash, you’re earning virtually nothing. Right?

Even a money market today will at least pay you, somewhere in the high threes. You can do better by owning bonds, and you can get somewhere into the low fives to mid fives. And that’s for investment grade bonds. If you’re willing to take on some credit risk, which we can touch on in a few moments, by lending to, say, b rated companies or double b rated companies, you can actually earn an even higher yield.

So those yields can reach into the 7% range. And if you own private credit, so these are…

This is debt issued by private companies, you can actually reach into the low double digits, perhaps 10 to 12% depending on whether or not the vehicle is taking leverage and things and things like that.

So the investment case for owning fixed income, certainly in an equity dominated portfolio, I think still remains quite quite strong.

So how should investors be thinking about bonds in our portfolios? And I think this is where we run into trouble. I think many of us as investors think, well, wait a minute. My bonds should never go down in value, or perhaps my bonds should provide me higher levels of income. And those are things that certainly we desire as bond investors, but bonds can really do really do one to two of three things. So there’s three things that bonds do in a portfolio.

Let’s begin with income. Right? We we hear that term fixed income. So they provide income. Alright? And you can invest for income, but if you wanna maximize income, you need to do two things with your bond portfolio, potentially three things.

You need to lend out your capital for longer periods of time. This is called the maturity or the duration. You wanna lend it out for long periods of time. So that means buying, like, a ten year bond or a fifteen year bond.

But the longer the term for the bond, the more volatile, the more sensitive that bond is going to be to changes in interest rates. And so you wanna be careful. If you lend out capital for very long periods of time at…

When interest rates are at only perhaps three and a half or 4% and interest rates go up, what you’re gonna see is a very big decline in the price of the bonds in your portfolio. Now you may say, well, that’s okay. I’m gonna hold the bonds to maturity. That’s fine.

I hear that all the time. But that doesn’t change the fact that the price of the bonds in your portfolio have declined and and perhaps quite significantly because interest rates have have risen. So so the number one reason that many investors invest in bonds is to get income. So you can do that.

So you can lend it out for very long periods of time, or you can lend it to less credit worthy investors, investors that perhaps have a somewhat compromised or weaker balance sheet. So these would be like your b rated companies. All of us have heard of high yield bonds. Well, high yield bonds is just a that’s a Wall Street euphemism for junk bonds.

Right? We used to call them junk bonds in the late eighties and early nineties. These are just companies that, you know, they don’t have that that a rated or double a rated polish from a, from a ratings agency.

So you would have to take what we call credit risk. You’re lending the capital to a borrower that has a relatively speaking weaker balance sheet. What do we mean by a weaker balance sheet? They probably have higher levels of debt relative to a rated companies or something like that.

Alright? So you have to take credit risk or you have to take term risk, which means lending it out for longer periods of time. So that’s how you would maximize income. So that’s one thing.

Now what are these other two things that bonds do in our portfolio? Number two, they provide diversification, and that’s critically important when you have an equity portfolio that is really dominating the risk in the portfolio. So how do you diversify that? Well, you naturally wanna diversify within equities, and we already do that for you at Mercer.

Right? You you wanna diversify within asset classes. You wanna have your factor tilts. You wanna own equities from different, different markets, different countries.

Right? British bonds, European bonds, Canadian bonds, Japanese bonds, and so on and so forth. But you wanna do the same thing within bonds. You wanna have a highly diversified bond portfolio, but you really wanna make sure that you’re engineering a bond portfolio that behaves differently than your equity portfolio that’s inside the…

Inside your account. So you want these things to behave a little differently. Alright? So you could do that.

Right? You can invest in bonds that perhaps pay lower income that behave differently from equities in your portfolio. So number one, you can invest in bonds for income. Number two would be diversification.

And last but not least, we invest in bonds for capital preservation.

This is for the part of the portfolio that we don’t expect to go down or at least not to go down by very much when bond markets are in trouble.

The challenge is capital preservation requires shorter duration bonds. It requires higher credit quality borrowers. Think the U.S. government. Think of a double a rated company.

Right? So the…

This desire for income, the desire for diversification, and the desire desire for capital preservation, these three things are intention to varying degrees. Alright? You should be working closely with your adviser to understand why exactly you own bonds in your portfolio, and you should be unequivocally clear on why you have bonds in your portfolio. We all know why we have equities in our portfolio.

That’s to provide long term growth. That’s our long term engine that’s gonna help us outperform inflation. It’s gonna help us build wealth in real terms and going to help us ultimately achieve the financial security, the economic freedom that we desire for ourselves and our family. So we know why we own equities.

Equally important, we need to know why we own bonds in the portfolio. So have that conversation with your adviser and be crystal clear on why we own bonds in the portfolio.

There’s one thing I wanna go back to that that I just remembered.

With respect to the investment case for bonds, right now, if you were to invest in, for example, just a broad bond portfolio earning about five, five and a quarter percent, that portfolio has a real yield, meaning real, meaning over and above inflation of somewhere around two and a half percent.

That’s critically important to keep in mind that the bond returns that you are earning today are delivering you income over and above the rate of inflation. Like I said, that’s why we own equities. But equally important, when you’re building out that bond portfolio, especially today, the great thing is is that you’re actually earning yields north of inflation. So bonds equally at the moment are helping your portfolio build that long term inflation beating power that all of us require in order to retire with a high degree of economic freedom.

Alright? So, again, that gets back to the investment case for for bonds. Alright? So many of you also ask, well, Don, what other strategies, bond strategies, does Mercer Advisors manage and offer to to our our clients?

And the short answer to that is we are active in every single bond asset class, every single different type of bond vehicle that’s available in the marketplace. Mercer today manages close to a $120,000,000,000.

And when you when you have a firm of that size, you are active in all of these major asset classes. We have strategies that invest directly in treasury bonds. So if you didn’t want a mutual fund or an ETF, we can just build out and hold a basket of U.S. treasury bonds. We also have third party managers, firms like BlackRock and PIMCO and Nuveen and many others that we work with to custom tailor and build things like various municipal bond portfolios, where you own bonds issued by the state of California or the state of New York or the state of Kentucky or Colorado.

And the logic behind that is municipal bonds, as many of you know, are tax exempt. And so for those investors looking for tax exempt income from their bond portfolio, we can easily do that. And we can easily build you one that would even potentially be tax exempt from state income. So I live in the state of Pennsylvania.

If I wanted to build portfolio of Pennsylvania municipal bonds, so it’s such that my income from that portfolio was both federal and state tax exempt, we could do that. We could do that. Alright? But work with your adviser on Alright?

My point is that we have a wide range of strategies. Strategies that invest in everything from ETFs to mutual funds to actually owning the individual bonds issued by corporations, by governments, by states. Right? So it just depends ultimately on what you’re looking for and what you need to really support your financial plan.

And there are pros and cons to all of these different vehicles. So don’t think for one minute that one of these is, automatically superior to all of the others. That’s not the case. It just depends on what you’re solving for.

ETFs are very liquid. You can trade those throughout the day. If you own individual bonds issued by corporations or municipal bonds issued by the state of Pennsylvania, well, those are less liquid. Trying to convert that to cash very quickly is going to be problematic.

Alright? So back to those investors who say, hey. It’s okay if the price of my bonds go down. I’m gonna hold them to maturity.

Keep that in mind. If you’re gonna own a basket of individual bonds, interest rates go up and your bond prices fall.

Remember that that was your logic. That’s why we wanted to own those because you’re gonna hold them until maturity. Maturity is when you are repaid the cash that you’ve effectively lent to the borrower.

A lot of people don’t like seeing that. You know, when you see those prices go down, that can be a little painful. ETFs, the challenge is you can’t see the individual bonds within the ETF. They’re there.

They’re definitely there. But the nice thing is if you needed cash now, you could call your adviser and say, I need you to raise 5,000, 10,000, $100,000 in cash from my portfolio, and we could quickly sell those ETFs and quickly get you your cash. Alright? So these different vehicles all have their own pluses and minuses.

Make sure you explore those with with your adviser. Alright? One last thing I will touch on is we are also active in private credit markets. So many of you have heard of private credit funds.

We we have portfolios that allocate to private credit. Private credit is the non publicly traded side of the market where you’re lending capital to private companies. Now the great thing about that is you are typically earning higher yields, somewhere in perhaps that 10 to 12% range, like, that I mentioned a little bit ago. Those are great yields.

The challenge is…

Keep in mind, right, there’s no free lunch in this world.

The challenge is is these are illiquid. Right? These are typically private partnerships or they’re funds that offer very limited liquidity. Perhaps once a quarter, they’ll redeem up to 5% of the fund’s outstanding, shares.

So those higher yields are not free. You’re giving up liquidity. You can’t just go into your Schwab account or your Fidelity account or your Raymond James account and point and click and try to sell that. You can’t do that.

They’re private. Alright? So there’s pros and cons here. All of these different tools in the toolbox have their place.

Just depends on the job to be done.

Okay? So don’t think for a moment again that one of these is automatically superior to the other. It just depends on what you’re trying to accomplish. So you can build a diversified portfolio at Mercer, and we we do this every day, where you have, of course, the equity component, but you have part of the bond portfolio focused on capital preservation, part of the portfolio focused on really diversifying out some of that equity risk that’s in the portfolio, and then another sleeve of the portfolio that’s focused on generating really high levels of income, and that could be a private credit component perhaps paired with some high yield bonds that can get you that seven, eight, 9% yields that perhaps you would be looking for to help sustain your lifestyle or whatever the case whatever the case may be. But discuss those with your discuss those with your adviser.

We’re here to help. That’s the idea. They know you best. They know your balance sheet.

They know your tax bracket. They know your marginal tax bracket, and they also know you. They understand your tolerance for risk. And none of these are risk free.

So keep that in mind. A lot of folks I think are erroneously think, they’re bonds. They shouldn’t be risky. No.

There are bonds that can be very high risk, you just wanna be very, very careful and make sure that you understand that risk is a spectrum. There’s no such thing as something that’s risky and then something that’s objectively not risky. Risk is a spectrum, and bonds fall all along that broader spectrum. So take your time.

Work with your adviser. Make sure you understand, number one, the role of bonds in your portfolio. Number two, what’s the what’s the best vehicles to include in your portfolio? Do I want individual bonds?

Do I want ETFs? Do I want mutual funds? What are the pros and cons? What is the tax treatment of the different types of bonds in my portfolio?

And then ultimately understand how bonds help you achieve long term economic freedom. Remember, bonds are just a tool. They’re a vehicle that we are using to help you achieve the financial goals and objectives for you and your family that you and your adviser have partnered together to help your family accomplish. So that’s it for today.

Thank you so much for giving us some of your precious time. If you do have any questions, please feel free reach out to your adviser and we’ll do our absolute best to get you an answer to your questions. Thank you so much.

This presentation by Mercer Global Advisors Incorporated also known as Mercer Advisors was intended for general information purposes only. No portion of the presentation serves as the receipt of or as a substitute for personalized investment advice from Mercer Advisors. All expressions of opinion reflect the judgment of the speaker as of the date of recording.