Bonds are pulling portfolios into negative territory, not stocks

Diversification is making it harder than usual to keep up with the S&P 500

Dec 5, 2018 @ 2:08 pm

By Jeff Benjamin

The stock market's 3% drop Tuesday provides the latest proof that volatility is back. But the recent gyrations in major stock market indexes doesn't tell the full story of what's happening inside client portfolios.

While marquee benchmarks like the Dow Jones Industrial Average and the S&P 500 are getting all the attention, it's the normally steady fixed-income component that is wreaking the most havoc on portfolio performance.

The S&P 500 is still up 2.8% from the start of the year, but the Bloomberg Barclays Aggregate Bond Index is down 1.3%, which will be dragging portfolios below the closely watched S&P.

"If you're diversified, there's always a piece of portfolio you're going to hate, but right now you're going to be unhappier about being diversified than usual," said Peter Lazaroff, co-chief investment officer at Plancorp Financial Services.

Even amid the increased volatility that has plagued the equity markets for most of this year, large-cap growth has been among the best-performing categories. According to Morningstar, the average large-cap growth fund is up 4.7% this year, followed by a 3% average return for small-cap growth funds.

Meanwhile, the corporate bond fund category is down 3%, and long-term government bond funds are down 4.7%.

"Fixed income is usually viewed as a safe haven for investors, but this year we saw a spike in interest rates," said Todd Rosenbluth, director of mutual fund and ETF research at CFRA.

"Investors tend to expect fixed income to provide downside protection within a diversified portfolio," Mr. Rosenbluth said. "It's a rare year when bonds have underperformed in a volatile market."

The last time the Barclays Aggregate finished a year in negative territory was 2013, when it dropped 2% while the S&P 500 gained 32.4%.

The impact of the bond market's pullback on diversified portfolios can be measured by the performance of target-allocation funds, which typically increase bond allocations to decrease portfolio risk.

Target-allocation funds with between 50% and 70% equities, which typically suggests more risk, are down an average of 1.87% this year, while allocation funds with between 30% and 50% equities are down 2.6%.

"Most clients do not expect to lose money in bonds, but they forget about the impact of things like interest rates and duration risk," said Case Eichenberger, senior client portfolio manager at CLS Investments.

"Over rolling one-year periods, bonds are positive 85% of the time," he said. "But bonds haven't been as much of a safe haven as you would expect."

Not only is the stock market getting all the attention, but the attention is disproportionately focused on declines in stock prices, said Paul Schatz, president of Heritage Capital.

"Monday was a big up day, and last week the S&P was up 4.5%," he said. "In the short term, selling in this market will look foolish."

Mr. Schatz is downplaying the bond market's inverted yield curve, which currently has some shorter-term notes yielding more than longer-term notes, which is considered a precursor to a recession.

"All the sudden the world woke up yesterday and saw that the yield curve inverted," he said. "Recessions are not a point in time, recessions are a process. The yield curve inverting on one day says absolutely nothing that it didn't say the day before."

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