Why Own Bonds?

Strong equity market performance in 2013 and still-low yields may cause investors to overlook the fact that bonds can still serve as an effective diversification tool. Following a year in which stocks returned 30% and bonds posted their worst return since 1994*, investor sentiment for stocks remains positive while bond sentiment is poor. The divergence in sentiment is evident in actual investment dollars. Inflows into stock mutual funds totaled $168 billion in 2013 versus a rare outflow for bonds, which totaled $82 billion. Our 2014 forecast calls for 10% to 15% returns for stocks and another challenging year for bonds with returns roughly flat^{^.}

The case for stock investing is strong but pullbacks can arrive without warning. As mentioned in our

Outlook 2014, we expect more volatility this year. In 2013, the stock market experienced only one brief pullback of just over 5%. Historically such calm is rare. Looking beyond 2014 the case for stocks over bonds is compelling, but for investors with shorter-term horizons protection against an equity market sell-off is prudent. After all, the average annual peak-to-trough decline in the S&P 500 from 1960 to 2013 has been 16%, and pullbacks can arrive without warning. Investors need to be prepared and bonds can help provide a buffer.

A look back at prior stock market pullbacks illustrates how bonds have historically provided good diversification benefits. Figure 1 shows all equity market pullbacks of 5% or more lasting three weeks or more over the past 10 years and the corresponding return for stocks and high-quality bonds. Figure 1 also illustrates the hypothetical return of a balanced 60% stock/40% bond portfolio and the dampening impact bonds can have on stock weakness. During stock market pullbacks in excess of 5%, bonds outperformed stocks on average by a double digit margin, a significant difference. Excluding the historic mid-2008 to early-2009 sell-off, the performance differential narrows but is still notable at a 9.6% advantage in favor of high-quality bonds.

In a few cases, both stocks and bonds declined together. This is a troubling outcome and reflects a failure of diversification, but it is rare. Still, bonds managed to outperform stocks on those occasions. In 2008, high-quality bonds provided a buffer but not without volatility, as investment-grade corporate bonds declined for the year and even high-quality mortgage-backed securities (MBS) suffered brief declines. While not all segments of the bond market perform similarly every time, an allocation to high-quality bonds has proven effective at offsetting stock market weakness.

Not About Yield

Today’s low-yield environment does not negate the diversification potential of bonds. During 2012, the stock market suffered two pullbacks greater than 5%, and bonds rose more than 1% over each period. The 10-year Treasury yield varied between 1.4% and 1.9% during the 2012 equity market sell-offs, much lower than today’s level.

In fact, during each stock market pullback in Figure 1 bond market performance is fairly consistent, averaging 1%, despite varied levels of interest rates. Two of the bond market’s strongest gains during stock market sell-offs occurred in 2010 and 2011, a post-recession period in which yields had already declined sharply.

Over short-term periods, price movement, not interest income, is the primary driver of bond performance. Interest income accrues slowly and although the primary driver of long-term bond returns, price changes, up or down, often overwhelm the impact of interest income over short periods of time. Therefore, a low-yield environment does not preclude bonds acting as a diversification tool.

Pension Buyers

Pension plans represent another investor group that can use bonds to address a specific objective. Pension investors, who have a very long time horizon and are therefore less sensitive to interest rate movements, use bonds to offset their long-term liabilities. Robust equity market gains in 2013 improved pension funding ratios broadly and reduced the need to take on additional risk to achieve investment goals. Following a year in which equities gained 30%, pension buyers took advantage of long-term Treasury yields near 4% and long-term corporate bond yields above 5% to better balance the risk-reward profile of their investment portfolios [Figure 2]. Pension buying, which has been a steady source of demand so far in 2014 and one reason why bonds are off to a good start, illustrates another way in which bonds can address specific investor objectives.

Conclusion

Low yields will likely translate into lower long-term bond returns, and therefore the hurdle for stock investors to beat bond performance over the long term is lower. However, for investors with shorter horizons or those simply unwilling to endure stock market swings, bonds can play a diversification role even in today’s low-yield environment. In conjunction with sectors that historically hold up better against rising rates, such as high-yield bonds and bank loans, an allocation to core bonds makes sense to help protect against potential stock market weakness.

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IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. Past performance is no guarantee of future results.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.

Stock and mutual fund investing involves risk including loss of principal.

Corporate bonds are considered higher risk than government bonds but normally offer a higher yield and are subject to market, interest rate and credit risk as well as additional risks based on the quality of issuer coupon rate, price, yield, maturity and redemption features.

Mortgage-backed securities are subject to credit, default risk, prepayment risk that acts much like call risk when you get your principal back sooner than the stated maturity, extension risk, the opposite of prepayment risk, and interest rate risk.

Treasuries are marketable, fixed-interest U.S. government debt securities. Treasury bonds make interest payments semi-annually, and the income that holders receive is only taxed at the federal level.

Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.

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INDEX DESCRIPTIONS

The Barclays Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

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This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.

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