Throughout history, good quality government bonds have offered investors shelter from the storm. That is still true today.
But with bond yields at historic lows, many investors are shunting bonds aside in favour of alternative investments that promise higher returns and lower correlation to stock markets. This trend picked up steam after the 2008-09 stock market panic in which markets worldwide fell at once.
Except the bond market. Indeed, the asset that is least tied to stock markets is in danger of being overlooked just when investors might need it the most.
While stock prices tumbled roughly 36.5 per cent in 2008, depending on the market, bonds rose more than 20 per cent. That's quite a gap. The same trend can be seen going back to 1929 with a few minor exceptions, according to data compiled by Aswath Damodaran, a finance professor and blogger based in the United States.
"I still think bonds are relevant to a portfolio," says Matthew Ardrey, vice-president of T.E. Wealth in Toronto. "We have an allocation to short-term bonds that is incredibly stable."
Bonds offer two key things to a portfolio, Mr. Ardrey says: liquidity and diversification. This is especially important to people who are retired, or nearing retirement, and who depend on their investments to supplement their income.
If the stock part of your portfolio is down 20 per cent, you can draw funds from the fixed-income side, Mr. Ardrey says. Bonds offer genuine diversification because they are the only broad asset class – besides cash and guaranteed investment certificates – that does not move in lockstep with stock markets.
Consider what happened during the recent market selloff from last May to late August. Stock markets everywhere flopped but bonds fell only slightly.
"Bonds are really the only assets treading water," Ben Carlson, a portfolio manager at New York-based Ritholtz Wealth Management, said at the time. "They provide not only an emotional hedge, but also act as the flight-to-safety asset class during a market panic," Mr. Carlson wrote in his blog, A Wealth of Common Sense.
With interest rates barely visible, bonds contribute little to investors' returns, so portfolio managers are reluctant to hold the usual allocation. Traditionally, a balanced portfolio has consisted of 60 per cent stocks and 40 per cent bonds. Worse, bond prices will fall when interest rates eventually rise. Bond investors face scant returns and a potential capital loss.
"We agonize over how many bonds we should own," says Tom Bradley, president of Steadyhand Investment Funds Inc. "In my 32 years in this business, I don't think I've faced a tougher time for building portfolios than right now."
The Steadyhand Founders Fund, a balanced portfolio, has a 25-per-cent bond allocation, well down from a more usual 35 to 37 per cent, Mr. Bradley says. He has shifted some holdings to cash and has begun buying more stocks now that prices have become more attractive.
"They're still a diversifier in the short term," Mr. Bradley says of bonds. "We saw that in the summer." In the August selloff, government bonds held up better than corporate bonds, he notes.
A relatively safe strategy is to invest in a one- to five-year bond ladder, said Warren MacKenzie, a principal at HighView Financial Group in Toronto. (An alternative would be a GIC ladder.)
"With a bond ladder, your cash flow is certain because one or more bonds will be maturing each year," Mr. MacKenzie says. Given the state of the world economy, "it is unlikely that interest rates will rise rapidly."
In a recent blog, Mr. Carlson compares the broad U.S. stock market index dating back to the late 1980s to the Vanguard Total Bond Market Fund, which investors can more readily hold than U.S. Treasuries. On average, stocks were down 16.5 per cent, while bonds were up 8.4 per cent.
That doesn't mean you should dump your stock holdings to buy bonds.
"Bonds have done their job," Mr. Carlson says, but stocks still rose in seven out of every 10 years and dominated bonds in overall performance, he notes. "You can't completely give up on equities just because they lose money sometimes."
Why own bonds?
Yields may be scant, but there are good reasons to own bonds, says Warren MacKenzie. Here are five:
- Bonds are an important part of a “goals based” asset mix, Mr. MacKenzie says. Investors should be well diversified and take no more risk than necessary to achieve their financial goals. “If they can only achieve their goals with a 100-per-cent equity portfolio, then they should take some time to re-examine their goals and their lifestyle before they are forced to make a dramatic change.”
- Bonds protect capital from a possible market crash.
- Bonds provide a source of funds for rebalancing. “If one is 100 per cent invested in equities and we have a 50-per-cent crash, the investor can’t rebalance [sell some bonds] to buy stocks when they are cheap because he has no liquid funds,” Mr. MacKenzie says.
- Bonds reduce what’s called the “sequence of returns” risk because they lower portfolio volatility. “If you are all in equities when a 50-per-cent crash comes and you need funds to live on, you will have to sell twice as many stocks because they will only be worth half as much,” he says. When prices recover, “you will have fewer stocks to rebound.”
- Finally, because they serve as a buffer to a portfolio, “bonds lower the probability that you will panic and sell out at the bottom,” Mr. MacKenzie says.