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Years of low interest rates have eroded investor faith in the basic portfolio-building strategy of mixing stocks and bonds.

And then came 2019, a year of falling interest rates and soaring bond funds. The lesson for investors: Bonds aren’t just insurance against stock market corrections. They also add performance at times when the economic outlook is worsening.

For the year through Nov. 30 (the latest available data), the FTSE Canada Universe Bond Index turned in a total return of 9.6 per cent (changes in bond prices plus interest payments). That’s better than double the index’s 10-year average annual return of 4 per cent. Note that the interest portion of the total return for bonds was minimal. The yield on Government of Canada bonds maturing in two through five years as of late December was just 1.7 per cent.

The rest of the return from bonds came from capital gains. Bond prices move in the opposite direction to interest rates, which means they jumped in 2019 as interest rates unexpectedly fell amid growing pessimism about the economy in Canada and globally.

Stocks did much better than bonds in 2019, so the bond skeptics who used dividend stocks as a replacement did just fine. But if the economic outlook weakens further and recession risk grows, bonds could outperform while stocks struggle. Stocks have thrived in the low-rate world of the past 10 years, but this can’t last indefinitely. Eventually, the economy will slip into recession and trigger a pullback for stocks.

One of the criticisms of using low rates to sustain economic growth is that central banks don’t have much room to cut further if a recession happens. But after a series of rate increases back in 2017-18, the Bank of Canada’s overnight rate now stands at 1.75 per cent. There’s room for the central bank to trim rates to support the economy, and that means there’s room for bond funds to appreciate further.

Bond skeptics, take note. Your dividend stocks may struggle if the economy worsens, while bonds deliver. An ideal way to put bonds in your portfolio is a broad-based bond ETF that holds government and corporate bonds and mixes short-, medium- and long-term bonds. The juiciest returns in 2019 came from long bonds, but you don’t want to overemphasize these in your portfolio. If rates were to turn higher, long bonds would be crushed.

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