Index Jun-04 QTD YTD Description
S&P 500 Index* 1.80% 1.30% 2.60% Large-cap stocks
DJIA* 2.42% 0.75% -0.18% Large-cap stocks
Nasdaq Comp.* 2.98% 2.65% 2.22% Large-cap tech stocks
Russell 1000 Growth 1.25% 1.94% 2.74% Large-cap growth stocks
Russell 1000 Value 2.36% 0.88% 3.94% Large-cap value stocks
Russell 2000 Growth 3.33% 0.09% 5.68% Small-cap growth stocks
Russell 2000 Value 5.08% 0.85% 7.83% Small-cap value stocks
EAFE 2.23% 0.44% 4.86% Europe, Australasia & Far East Index
Lehman Aggregate 0.57% -2.44% 0.15% U.S. Government Bonds
Lehman High Yield 1.43% -0.96% 1.36% High Yield Corporate Bonds
Calyon Financial Barclay Index** -2.51% -7.28% -3.92% Managed Futures
3-month Treasury Bill 0.43%
All returns are estimates as of 06/30/2004.
*Return numbers do not include dividends.
** Returns as of 06/29/2004.

With the markets officially in a rising rate mode, a plethora of investment advisors are likely fielding the same question from investors: “Why should I own bonds?”

There’s little doubt that rates are poised to increase, but that does not necessarily mean that the total return of fixed-income securities will head straight down. If that were the case, I wouldn’t just sell bonds, I’d short-sell them.

The most compelling reason for including bonds in a portfolio is diversification. Consider the 1970s, a decade when interest rates increased from 5% to 14%. According to a recent Ibbotson study, an investor with a 30% allocation to bonds during this period captured 98% of the total return of stocks with only 73% of the price volatility.

If that statistic isn’t convincing enough, consider the possibility of another market shock, be it a stock market crash a la 1987, or another terrorist attack on U.S. soil. In the past, bonds acted as a shock absorber during such tumultuous events, cushioning the bruising performance of equities.

Even so, a checkup on the fixed-income portion of clients’ portfolios is certainly in order. When it comes to bonds, efficient-market aficionados have long prescribed a mix of short-duration, high-quality issues, a mix that makes for a great anchor. A cheap way to capture the low end of the yield curve is by purchasing an exchange traded fund like the iShares Lehman 1-3 Year Treasury Bond (SHY). I also advocate a bit of high yield, since credit spreads seem to perform well during periods of rising rates. In the interim, we’re avoiding mortgage debt, with the concern that a sudden increase in rates may lead to convexity-induced selling.

Regardless of economic conditions, bonds should be a part of every long-term investor’s holdings. It is prudent, however, to adjust duration and credit spread exposure as conditions change.

Contact Robert F. Keane with questions or comments at:

bkeane@ia-mag.com.