The yield on the 10-year U.S. Treasury Note ended the quarter at 0.65% and after adjusting for expected inflation, yields are negative in “real” terms for high quality government bonds. This means that the purchasing power of the income generated from government bonds will likely fail to keep pace with the increase in the price of goods and services over time. While bonds offer safety in the form of low volatility and return of principal, return on capital will be scarce at best and the expected total return for this asset class will remain quite low. While a low return may be hard to accept, there are several reasons why we continue to own bonds in client portfolios.
First, high quality bonds offer a significantly higher interest rate and income when compared to cash. We have focused our fixed income investments in high quality corporate bonds. On average, these bonds yield between 1-2%, versus 0.1% on a typical money market vehicle. While cash is useful to meet near term capital and distribution requirements, we are migrating away from cash in favor of short and intermediate term bonds as well as bond funds where the investment horizon allows.
Second, bonds offer a diversification benefit in the form of low correlation versus equities. While stock prices fluctuate over time, high quality bond prices remain generally stable. Their stability helps cushion the impact of price changes on a broad portfolio over time.
Third, because of their relatively low volatility, bonds can be a source of capital to draw upon without having to sell stocks at an inopportune time. Using the proceeds from sold or matured bonds may
result in lower capital gains taxes and provide greater flexibility to meet distribution needs without sacrificing longer-term growth.
Finally, high quality bond yields are very safe. Corporate balance sheets remain generally healthy, and we are highly attentive to the financial flexibility and cash-generating abilities of the companies we invest in for our clients (including both bonds and stocks). So, while bond returns are likely to remain low, bonds offer capital preservation and return of principal, and enable us to better manage a broad portfolio for the short and long term.