What are bonds and what’s ahead for the bond market in 2018? Our Managing Director of Fixed Income Eric Kelley provides thoughts on these questions and items investors should be considering when evaluating bonds for their personal investment portfolios.

What are bonds and what role do they play in a healthy portfolio?

Bonds are a risk-mitigating asset class. They lower the total volatility of portfolio returns and provide protection against turbulence in the global economy and equity markets. Yields and returns are currently below long-term averages, but bonds still play an important role in portfolio diversification and risk management.

How does tax bracket affect bond selection?

Ultra-High-Net-Worth (UHNW) investors are likely to continue to be in tax brackets above 30 percent, and will, therefore, still make heavy use of municipal bonds (munis). For high-tax-bracket investors, munis deliver higher after-tax yields and less price volatility (compared to taxable bonds).

For investors in lower tax brackets or investing via tax-sheltered structures (IRAs, foundations, etc.), corporate bonds have been a very popular alternative. Both investment grade (BBB-rated and higher) and High Yield (BB and lower) corporate bonds deliver higher yields than risk free bonds (Treasuries and US Agencies). This higher yield comes with a trade-off, since corporate bonds have higher price volatility than either munis or governments.

Investors need to be very cautious when purchasing bond funds since managers often increase yields by reaching for very long maturities and/or higher levels of credit risk. Both of these strategies can dramatically increase price volatility of the funds. As such, investors need to be sure that they understand exactly how the fund manager is delivering their returns and exactly what amount of volatility to expect moving forward.

How do individuals find the right portfolio balance and then sustain it? 

This is a question of risk appetite. Investors need to consult with their financial advisor to review expected returns and volatility for the various combinations of asset classes (asset allocations). Investors should review the full range of expected and best/worst case scenarios for various blends of stocks/bonds, then choose a risk profile that is appropriate for their return needs and risk tolerance.

They should then re-balance back to their chosen targets on a regular, disciplined schedule and be prepared to keep a long-term perspective when the inevitable market turbulence occurs.

Some investors have a negative perception of bonds. Why is that?

Bonds have become less popular as yields fell to nearly zero during the Quantitative Easing period from 2009–2016. With bond yields lower than investors had ever seen in their lifetimes, many were lured into heavier exposure to equities.

What is your outlook for the bond market in 2018? 

“What are bonds?” is an important question to know the answer to, as it would seem yields are poised to do well in 2018. Yields are expected to rise modestly throughout 2018, finally moving most fixed income categories above two percent yields for the first time in an extremely long time. Money market rates may be close to two percent by year-end, and the broad bond markets could be above three percent. This will be welcome news for retired investors, as they will finally be able to earn somewhat reasonable income streams from lower risk investments.

Investors should be prepared to deploy money into the bonds markets during the second half of the year, as rates move upward in response to ongoing moves from the Federal Reserve. If the economy and markets stay on track, the second half of 2018 is likely to deliver bond yields that investors have not seen in more than a decade.

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