A recent post at White Coat Investor suggests that investors should not fear rising interest rates when considering whether to include bonds in their portfolio. https://www.whitecoatinvestor.com/bond-investors-should-not-fear-rising-interest-rates/ It’s worth reading in its entirety. The main concerns about bonds and bond funds are that returns are poor, and bond funds can decline with rising interest rates. All true, but in some respects the post misses the point of what really scares investors: credit risk.
As mentioned in the article, interest rates do not necessarily have to increase. They are low now, and have been low for a decade, after the collapse of 2008.
What looks like a poor yield today could look wonderful a few years from now. For example, in October 2019, the 10-year US Treasury yield was 3.45%, but today it is 1.76%, half of what it was at the earlier time. Through this whole time, experts have been forecasting higher yields in the future. For a while in 2018, it seemed that a long-term low in yields had been reached, and that the long-anticipated upward trend was taking hold. But just a year later, we are again testing new lows in yields.
The White Coat Investor post goes on to explain many other good reasons to have some part of one’s investments in bonds. Generally, bonds are less volatile than equities, but when they default, it’s usually a disaster.
Credit risk cannot be overlooked in bonds. Even top-rated investment-grade corporate bonds defaulted during 2008-2010: Lehman Brothers AAA-rated bonds sold for pennies on the dollar, yet analysts who rated them suffered no consequences. General Motors bondholders experienced an even worse fate. Municipal bonds are not immune.
It is not hard to see why people are still reluctant to invest in bonds, given their unattractive yields, limited upside potential, and recent history. Yet, bonds, especially debt of the US government (which has never yet defaulted) play an important role in reducing the investing risks of most individuals and families. Careful diversification in bonds, using mutual funds or ETFs can manage credit risk, but the ratings agencies have yet to recover from being completely discredited in the last downturn. It is impossible to predict what may happen in the next one.
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