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Why own bonds?

Five issues for fixed income investors to consider and defensive ideas for today’s environment.

Longer-term interest rates are rising and some fixed-income investors are asking: Should I sell my bonds? After all, with rates relatively low, new bond purchases generally offer investors modest income opportunities at best.

We believe fixed income can continue to play an important role inside a well-diversified portfolio, even in a rising interest rate environment. Before investors make changes to how much of these investments they hold, we recommend they consider these five characteristics:

  • Performance
  • Diversification
  • Volatility
  • Yield
  • Liquidity

Performance

Although the years of strong fixed-income returns appear to be behind us, that does not suggest the opposite — significant losses — are on the horizon for disciplined investors. In fact, even in a rising-rate environment, a well‑diversified bond portfolio may provide positive returns.

However, after multiple years of high single-digit or low double-digit positive returns, bond investors may have unrealistic expectations. The current environment in which short-term rates are near zero while longer-term rates are rising is likely to drive below-average returns.

Keep in mind that bond total returns comprise two factors — price movement and yield (current income).

Why investors should consider total return

Price return (gray bar segments), is only half the fixed-income picture. Total return (blue line), which also takes yield (current income) (gold bar segments) into consideration, is a more accurate barometer. The graph shows the Bloomberg Barclays U.S. Aggregate Bond Index returns.

Bar graph depicts yield (current income) and price return, resulting in a line showing total return. Y-axis: percent return; x-axis: 1994 to 2020. In negative years for price return (1994, 1996, 1999, 2005, 2013, 2015, and 2018 are the primary examples), negative return reduces the positive effects of yield. In the years 1994, 1999, and 2013, this actually resulted in negative total returns (all less than -5%). But in positive years for price return (15 of the 27 years shown), it is added to yield, increasing total return (generally above 5%). In 1996, for example, price return was negative but the total return was positive. In 2000, looking at price alone would understate a total return of over 10%. In 2013, positive yield couldn’t compensate for negative price return. Sources: Bloomberg Barclays U.S. Aggregate Bond Index and Wells Fargo Investment Institute. Data shown is from January 1, 1994, through December 31, 2020. The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based measure of the investment-grade, U.S.-dollar-denominated, fixed-rate taxable bond market. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

Diversification

The foundation of modern portfolio theory suggests that having a well-diversified mix of major asset classes, primarily stocks, fixed income, and cash alternatives, may help investors take advantage of different market environments and optimally balance risk and return. By drastically reducing or removing an asset class, such as fixed income, investors may take on additional risk as they become more concentrated in their remaining investments.

Volatility

For investors looking to generate higher returns in the current bond market environment, we recommend discussing current investment objectives and risk tolerance with your investment professionals. Moving investments into an asset allocation model expected to generate higher returns may be an option if increased volatility may be tolerated in a portfolio.

Yield

Investors receive different yields depending in part on the maturity of a bond purchased. This spectrum of yield across maturities is referred to as the “yield curve.” Typically, investors will receive a higher yield by buying a longer maturity. However, rather than simply selecting a longer-maturity bond to receive the highest possible yield, first consider the marginal benefit in moving out further on the yield curve.

Liquidity

Another reason to hold fixed-income positions is to help meet liquidity needs. Most bonds have a maturity at which time, if the issuer has not defaulted, principal is returned to the investor. If it is possible to anticipate when cash may be needed for a significant purchase down the road, buying bonds with a maturity near the time when money is needed can be an effective way to stay invested in the markets while maintaining some assurance that funds may be available when needed.

Our advice to bond investors

We acknowledge that fixed-income investments are likely to underperform relative to their recent and longer-term track record. For investors willing to tolerate volatility in the search for better returns, a shift out of fixed income and into a more aggressive asset allocation strategy may be appropriate. In addition, we have been leaning more heavily into stocks over bonds in most of our strategic asset allocation models but are careful not to add too much volatility for risk-averse investors.

A concentrated asset allocation strategy can be risky, so we generally recommend investors avoid them. While such a strategy can produce outsized returns, it can also lead to outsized losses — a scenario most investors are uncomfortable with.

Risk factors

Asset allocation and diversification cannot eliminate the risk of fluctuating prices and uncertain returns and do not guarantee profit or protect against loss in declining markets.

Investments in fixed-income securities are subject to interest rate, credit/default, liquidity, inflation, and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high-yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. If sold prior to maturity, fixed-income securities are subject to market risk. All fixed-income investments may be worth less than their original cost upon redemption or maturity.

U.S. government securities are backed by the full faith and credit of the federal government as to payment of principal and interest. Unlike U.S. government securities, agency securities carry the implicit guarantee of the U.S. government but are not direct obligations. Payment of principal and interest is solely the obligation of the issuer. If sold prior to maturity, both types of debt securities are subject to market risk.

Treasury Inflation-Protected Securities (TIPS) are subject to interest rate risk, especially when real interest rates rise. This may cause the underlying value of the bond to fluctuate more than other fixed-income securities. TIPS have special tax consequences, generating phantom income on the “inflation compensation” component of the principal. A holder of TIPS may be required to report this income annually although no income related to “inflation compensation” is received until maturity.

Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. Municipal bonds are subject to credit risk and potentially the alternative minimum tax (AMT). Quality varies widely depending on the specific issuer. Municipal securities are also subject to legislative and regulatory risk, which is the risk that a change in the tax code could affect the value of taxable or tax-exempt interest income.

Mortgage-backed securities will be subject to prepayment, extension, and call risks. Changes in prepayments may significantly affect yield, average life, and expected maturity. Extension risk is the risk that rising interest rates will slow the rate at which mortgages are prepaid. Call risk is the risk that if called prior to maturity, similar-yielding investments may not be available to purchase. These risks may be heightened for longer-maturity and longer-duration securities.

Preferred securities have special risks associated with investing. Preferred securities are subject to interest rate and credit risks. Preferred securities are generally subordinated to bonds or other debt instruments in an issuer’s capital structure, subjecting them to a greater risk of nonpayment than more senior securities. In addition, the issue may be callable, which may negatively impact the return of the security.

Bank loans are subject to interest rate and credit risks. They are generally below investment grade and are subject to defaults and downgrades. These loans have the potential to hedge exposure to interest rate risk, but they also carry significant credit and call risks. Call risk is the risk that the issuer will redeem the issue prior to maturity.

Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets.

Definitions

The Bloomberg Barclays Municipal Index is considered representative of the broad market for investment-grade, tax-exempt bonds with a maturity of at least one year.

The Bloomberg Barclays U.S. Agency Index includes native currency agency debentures from issuers such as Fannie Mae, Freddie Mac, and Federal Home Loan Bank.

The Bloomberg Barclays U.S. Aggregate Bond Index is a broad benchmark index for the U.S. bond market. The index covers all major types of bonds, including taxable corporate bonds, Treasury bonds, and municipal bonds.

The Bloomberg Barclays U.S. Corporate Bond Index measures the investment-grade, fixed-rate, taxable corporate bond market. It includes U.S.-dollar-denominated securities publicly issued by U.S. and non-U.S. industrial, utility, and financial issuers.

The Bloomberg Barclays U.S. Corporate High Yield Index covers the universe of fixed-rate, non-investment-grade debt.

The Bloomberg Barclays U.S. Mortgage Backed Securities (MBS) Index includes agency mortgage-backed pass-through securities (both fixed-rate and hybrid adjustable-rate mortgage) guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC).

The Bloomberg Barclays U.S. TIPS Index represents inflation-protection securities issued by the U.S. Treasury.

The Bloomberg Barclays U.S. Treasury Index includes public obligations of the U.S. Treasury with a remaining maturity of one year or more.

The J.P. Morgan Emerging Markets Bond Index (EMBI Global) currently covers more than 60 emerging market countries. Included in the EMBI Global are U.S.-dollar-denominated Brady bonds, Eurobonds, traded loans, and local market debt instruments issued by sovereign and quasi-sovereign entities.

The J.P. Morgan GBI Global ex-U.S. Index (Unhedged) in USD is an unmanaged index market representative of the total return performance in U.S. dollars on an unhedged basis of major non-U.S. bond markets.

The J.P. Morgan Government Bond Index-Emerging Markets Global is a comprehensive global local emerging market index and consists of regularly traded, liquid, fixed-rate, domestic currency government bonds.

The J.P. Morgan Non-U.S. Global Government Bond Index (Hedged) is an unmanaged market index representative of the total return performance, on a hedged basis, of major non-U.S. bond markets. It is calculated in U.S. dollars.

The S&P U.S. Preferred Stock Index is designed to measure the performance of the U.S. preferred stock market. Preferred stocks pay dividends at a specified rate and receive preference over common stocks in terms of dividend payments and liquidation of assets.

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector, or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to any particular investor or potential investor. This report is not intended to be a client-specific suitability or best interest analysis or recommendation; an offer to participate in any investment; or a recommendation to buy, hold, or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs, and investment time horizon.

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