Since late February, U.S. equity and bond markets have been historically volatile—on the same level of the 2008-2009 Global Financial Crisis in fact. In March, we saw the fastest bear market correction in the S&P 500 Index on record. Rates are hovering around all-time lows, the U.S. Federal Reserve cut short rates to zero, and global governments have enacted massive stimulus plans to try to alleviate some of the economic pain. From both a human experience and capital markets perspective, these are truly unprecedented times.
For bond investors, this seismic shift in the markets can create an immediate urge to act, and quickly. But before acting, I believe it’s best to pause and ask yourself, why do I own bonds?
Investors I talk to point to three key reasons:
1. Diversify equity risk
The importance of equity diversification has taken center stage over the past several weeks as the S&P 500 has entered a bear market. The logic behind diversification is that most investments don’t move together in the same direction at the same time. If an investor holds different types of investments, their gains and losses can potentially offset each other and make the investment experience smoother. If you take the S&P 500 to represent the stock market and the Bloomberg Barclays Aggregate U.S. Bond Index for the bond market, it’s easy to see that stocks and bonds tend to have an inverse relationship. Their correlation over the past 10 years has been close to zero—meaning stocks and bonds generally go their own ways. And that’s a good thing, because it’s less likely that stocks and bonds in a portfolio both go down in price at the same time. Hence, returns would be less volatile over time.
Investors can clearly see diversification in action when equity markets are down and bond investments are there to potentially provide stability to the portfolio.
The below chart compares core bonds (represented by the Bloomberg Barclays Aggregate U.S. Bond Index) against the S&P 500 during previous periods of equity market downturns, including the start of the COVID-19 crisis. As you can see, core bonds have been a strong hedge against equities during these stressed events.
Why? When stocks fall, money often moves from stocks to bonds—so called “flight to quality”—pushing bond prices up. Prices tend to go up more for bonds with higher levels of interest rate risk. For this reason, fixed income investments that have medium to high levels of interest rate risk provide better diversification to equities than investments with low levels of interest rate risk. This is a very important point, and one that is often missed by investors: If you hold bonds to diversify equity risk, you want interest rate risk.
2. Generate income
Income is a bit more intuitive. Most bonds and bond funds pay income on a regular basis, and many investors look for income from their bond portfolio. As a rule of thumb, bonds that carry higher levels of risk pay tend to pay higher levels of income. The two most common forms of risk in fixed income markets are interest rate risk and credit risk, and most bond investments carry one or both of these risks. A quick rundown: Short-term Treasuries have no credit risk and very little interest rate risk, and as a result they pay a low level of income. A core bond fund with a medium level of credit and interest rate risk pays a higher level of income. A market like high yield bond may only have medium interest rate risk, but its high credit risk could mean high income.
Remember, there is no free lunch here. To get income, investors have to be willing to take on risk. One of the big trends in recent years has been to move away from core bond allocations and into solutions that invested more heavily in high yield bonds and emerging market debt—a practice commonly referred to as “reaching for yield”.
These options may offer more yield, but at the expense of less equity ballast when investors need it most. The below graph once again shows how these asset classes have performed in equity market sell offs. As you can see, including large allocations to these types of securities as part of your fixed income portfolio could have hurt you when you wanted the buoyancy of bonds.
So, what’s the solution if you need income and equity diversification? Don’t just look at yield and total returns. Try looking for investments that have a history of strong performance, but also have a low correlation to equities.
3. Protect principal
Investors who want to use bonds to protect the principal of their investments do not want to see prices drop dramatically with the market. Short-term Treasuries such as T-bills are a popular choice for this purpose because of their low level of interest rate risk and credit risk. In fact, when thinking about principal protection, it is most important to keep both types of risk in mind. Don’t become preoccupied with one and forget about the other.
Consider this scenario: An investor is worried about interest rate risk but still hopes for some income from investments. Bank loans offer a high yield and stand out from a list of potential low interest rate choices. The problem? Bank loans are similar to high yield bonds in that they carry a high level of credit risk. While they may fare well in a volatile interest rate environment, they would likely fall in price should there be a credit event. Investing in bank loans probably won’t help investors protect principal, and neither would a portfolio that is tilted heavily toward risk.
Shorter dated bonds with both low credit and interest rate risk may be appropriate for this objective. However, it’s important to note that no market security is impervious to temporary periods of market stress or liquidity issues.
Today’s truly unique environment of ultra-low bond yields and sky-high equity market volatility is another good reminder that no single bond investment can achieve diversification, income and principal protection at the same time. More than ever, it makes sense to understand what you want your fixed income investments to do and invest accordingly, helping you stick with your long-term investing goals.