With bond yields rising steadily this year and many investors convinced that the 10 year US Treasury yield will soon break 3%, it begs the question, are my bonds safe? Is the so-called risk free asset truly without risk? And does it still serve a stabilizing function in my portfolio?
We believe that a well diversified portfolio should have risk assets of global equities including natural resources, real estate, and infrastructure, and high yield bonds. We also believe that there should be a risk control portion of the portfolio comprised of high quality investment grade bonds, cash, and inflation protected bonds, or TIPS. The purpose of the risk control portfolio is to help absorb volatility and provide stability when equities have a tough year.
But what happens when bond yields rise and it's the high quality risk control asset causing the volatility? Let's do some math. Even when bond yields rise, bond prices are not as volatile as you might think if you have a long term horizon-- let's say at least a year. If you bought the US five year treasury today at a yield of 2.6% and yields then rise another 0.5% over the next year, your bond would still earn 1.4% in total despite a loss in capital. That would give you an ending yield of 3.16%, which is much higher than we expect given our view of the economy, inflation, and likely Fed action.
But let's say we're wrong. How much do yields need to rise before your five year bond loses money over a year? Just under 1%. So we think you have a pretty good cushion before your risk control asset loses money. Here's another perspective. The S&P 500 equity index lost 11.8% from the peak on January 29th of this year to the recent trough on February 9th. That is just 11 trading days.
How much would the five year treasury yield have to rise before you loss 11.8% percent over a full year, not even 11 days? A whopping 4.5%. The yield would need to rise to 7.2% before you lose as much money in a year with the five year treasury that you could have loss in equities over 11 days.
And so yes, high quality bonds are still very much a risk control asset. So please don't be afraid of the bonds in your portfolio. They serve a purpose for long term investors and that purpose is risk management.