Believe it or not, there is still a case for owning bonds.
Even with yields as miserably low as they are right now, bonds can still do things stocks can’t – like buffer your wealth against serious downturns.
Yet many people now write off bonds as antiques. Skeptics point to the dismal payouts – a mere 0.54 per cent a year on the benchmark 10-year Government of Canada bond, for instance – and compare that with far more generous dividends available from stocks.
Why would anyone want to hold a bond that pays barely half a per cent, the skeptics ask, when you can instead buy shares of blue-chip companies and reap dividends in excess of 4 per cent?
The answer is that comparing relative payouts misses the point. Stocks and bonds play different roles in your portfolio.
You buy stocks to pursue high returns. You buy bonds to ensure safety.
Bonds are there for the rare, brutal occasions when the economy sours, dividends fall and stocks tumble. Bonds can shield your wealth during those rough patches and prevent you from having to liquidate your stocks at their lowest point. Better yet, bonds can provide you with the wherewithal to take advantage of any stock market bargains that emerge.
The two assets perform best in different environments. Stocks shine during periods of rapid economic growth. Bonds do best when the economy is in retreat.
Which type of period are we entering? No one knows. And that is precisely the point. Wise investors aim to protect themselves against whatever scenario might come.
The easiest way to do that is by holding both stocks and bonds. A mix of the two can protect you from catastrophe at the cost of only slightly lower returns overall.
History tells the tale: An all-stock U.S. portfolio would have produced an average annual return of 10.1 per cent from 1926 to 2018, according to Vanguard. However, the all-stocks approach would also have suffered some appalling losses – including a 43.1 per cent plunge in 1931.
In contrast, a balanced portfolio of 70 per cent stocks and 30 per cent bonds would have generated a 9.1 per cent annual average return over that period – nearly as good as its all-stock sibling – while suffering no single-year loss greater than 30.7 per cent. That would still have been painful, to be sure, but not nearly as painful as the shellacking suffered by the all-stock portfolio.
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So why aren’t more investors sold on bonds’ diversification benefits? The biggest problem, these days, is the paltry yields.
But investors should remember that stocks and bonds don’t exist in separate universes. They are two complementary ways to view the same underlying economic facts.
Bond yields are low right now because so many smart investors think the outlook for economic growth is dismal. They are willing to take any guaranteed yield they can find. But if these investors are correct, the outlook for corporate profits – and for future share prices – is poor, too.
Put it all together and the case for bonds hasn’t changed as much as you may think. Both stocks and bonds look expensive from a historical perspective, but the relative attractiveness of the two asset classes is pretty much as it has always been.
Historically, bonds have generated average annual returns of around 5 per cent, while stocks have produced average annual returns around 10 per cent. That works out to a five-percentage-point premium for owning stocks.
And today? According to asset manager BlackRock, Canadian bonds seem likely to deliver returns of around 1 per cent over the decade ahead compared with 6 per cent for stocks.
The five-percentage-point premium hasn’t budged in any substantial way. Neither has the relative volatility of stocks and bonds. Holding a chunk of bonds still makes good sense for investors looking to hedge the risks of owning shares.
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Ian McGugan