While any negative performance can be difficult, negative fixed income returns can feel particularly shocking. Year to date, many bond funds are down. However, declines within the bond market are not unprecedented. Sometimes people think of bonds as investments that will never have negative performance, but that is not the case. To enjoy the potential rewards of investing in bonds, investors must take on some risk.
Exhibit 1 illustrates rolling 3 month returns of the Bloomberg U.S. Aggregate Bond Index. It may be surprising to see that 3‐month periods in which returns for this index have been negative are not uncommon. However, by expanding the time horizon to 12 month rolling periods in Exhibit 2, we gain perspective. Going back to 1976 (as far back as we have data for this index) there are far fewer negative periods. While this won't match the exact experience of investors, it shows the power of a long‐term approach. No one can predict what will happen moving forward but having a plan you can stick with may help in short‐term periods of volatility.
- Tune Out the Noise ‐ With Fed officials signaling a more hawkish policy stance1, some market participants might choose to switch to cash or shorter‐duration bonds. However, the analysis in Dimensional’s recently published article, All Eyes on the Fed? A Look at Federal Funds Rate, Bond Return, and Term Premium, does not support the idea of allocating towards cash or shortening duration in response to changes in the federal funds rate. The timing and direction of changes to the federal funds rate is difficult to predict and doesn’t indicate how other interest rates and market participants will react.
- Use Information in Bond Prices ‐ Bond prices reflect the aggregate expectations of market participants. Investors can rely on current term spreads, the yield difference between longer duration bonds and shorter duration bonds, for information about expectations of returns. Research shows that current term spreads reliably forecast future term premiums.2 A systematic strategy that dynamically varies its duration and currency allocation based on current term spreads across yield curves is a robust way to target higher expected returns in fixed income.
- Tax Loss Harvesting is a potential action item. During market downturns, clients may work with their financial advisor to manage tax liabilities through loss harvesting opportunities. Certain clients may choose to sell in order to realize capital losses, which they may use to offset current or expected future capital gains.
- Stay Invested ‐ A skilled financial advisor can help develop an asset allocation and plan designed for unique goals and risk tolerance. To potentially enjoy the benefits of higher expected returns, investors should be willing to accept increased uncertainty. A key part of a good long‐term investment experience is being able to stay with your investment philosophy, even during tough times. A thoughtful, transparent investment approach can help investors prepare to face uncertainty. This may improve their ability to stick with their plan, tune out the noise, and potentially capture the long‐term returns the capital markets have historically provided.