Two Questions for Bond Investors

Last year, the Barclays Aggregate bond index (the Agg) gained 5.97 percent. Overall, our bond portfolios earned less than that – not a lot less, but less (it varies among clients, so I will be intentionally vague here).

Also, while our returns were less on a relative basis, we are happy with the absolute number – mid-single digit returns are not too shabby for bond investors in the current interest rate environment.

While we would prefer to outperform the index (and we know you would too), we don’t feel too badly about the underperformance in 2014 and suspect that you won’t either when you hear why.

We view bonds as the safe side of the portfolio. Everyone knows that stocks are risky and while bonds can, and definitely do lose money from time to time, the magnitude of the losses is not the same, provided that the bond portfolio is well diversified.

Our underperformance last year was because we didn’t take enough risk and had inflation protection that we didn’t need.

The primary factor that drives bond returns is the length of the bond, or as we call it, the duration of the bond. Short-term bonds don’t move much because they are close to maturity and will get the full face value and long-term bonds swing around a lot because the maturity is in the distant future and there is a lot uncertainty between now and then.

Our portfolios, on average, have about a five-year duration. Some are longer and some are shorter, but that’s our target. Right now, the Agg has a six-year duration, so our portfolios have less interest rate risk than the Agg. If rates go up, we should be hurt less and when rates fall, we won’t do as well.

Last year, in what I think is one of the big surprises of the year, rates fell dramatically and the longer the bond, the better your portfolio looked. In 2013, when rates rose, it was just the opposite. We’re happy with our duration at this point and don’t feel bad about being a little safer with the safe side of the house.

The second reason that our portfolios didn’t fare as well as the Agg is that we have two specific inflation protections built into the portfolio. First, we allocate about 10 percent of the bond portfolio to Treasury Inflation Protected Securities, or TIPs.

TIPs fare well in periods of unexpected inflation. Well, last year, we had the opposite – unexpected disinflation (I guess I’m not sure whether disinflation or deflation is the opposite of inflation, but we had disinflation).

Furthermore, market expectations for inflation fell dramatically last year, which meant that the Barclays TIPs index gained 3.64 percent. That’s not a bad return, but it’s not as high as the Agg, so we underperformed.

We also have five percent of our bond allocation invested in a fund that buys global bonds from developed markets (including the US).

Some portion of the portfolio, which changes over time, is left unhedged, meaning that the value of the portfolio changes along with changes in the US dollar. Since the dollar strengthened, having any non-US dollar exposure hurt last year.

In this fund, we posted a small loss, and while I can’t name the fund, I can say that it did much better than the Citigroup World Government 1-3 Year Unhedged Bond index, which lost -5.61 percent.

If the dollar had fallen, that could lead to inflation and, in theory, this fund would have been a nice source of inflation protection.

In the end, I’m mildly frustrated that we underperformed the Agg, but this is not a mea culpa. I only have to ask myself two questions to feel good about our bond portfolio:

1. Should we take more or less risk than average? Think of the average as the overall market.

2. Should we have specific inflation protection built into our bond portfolio?

The answers seem obvious to me and I’m betting that they were for you too.