In the wake of the recent market correction, several callers into my Sunday morning radio show, “Money Matters” on WSB Radio, have asked whether bonds are still an effective way to insulate a portfolio against stock volatility. Behind this question lies the worry that during the most recent stock pullback, we’ve also seen a fall (albeit minor) in bonds as well. The short answer to this question is yes. Despite the mild turbulence we have seen in the bond market, many bond categories still have an essential role to play for many investors.
Let’s first review what history tells us about the relationship between bonds and stocks during a variety of environments.
Diversification, or asset allocation, is typically used to limit portfolio risk. Two important components that traditionally make up a well-balanced or asset-allocated portfolio include both stocks (risky) and bonds (conservative). The idea is that when stocks correct (down 10 percent, 20 percent, 30 percent), bonds (particular high-quality bond categories like U.S. Treasuries) should move in the opposite direction, thus providing a buffer against those stock losses.
During the great financial crisis, for example, the S&P 500 stock index dropped 36 percent across 2008, while three-month government bonds returned 1.59 percent and 10-year Treasury bonds returned a whopping 20 percent. On the flip side, in 2013, the S&P 500 was up 32 percent while the 10-year Treasury bond was down 9 percent. In 2009, when U.S. stocks rebounded from the great financial crisis and finished up 26 percent, the 10-year Treasury bond total return was down 11 percent.
Bond prices and interest rates move in an inverse relationship. When interest rates fall, bond prices rise, and vice versa. So, when we see significant interest rate moves (whether up or down), overall bond returns (in either bond funds, ETFs or individual bonds) respond.
Typically, interest rates fall because the economy is in bad shape and the Federal Reserve is lowering rates in an attempt to make borrowing money cheaper and to help the economy out of a slump or recession. Such periods of slumping economic activity and falling interest rates are generally also a time when stock prices are sliding due to lower corporate earnings. But bond prices rise on the falling interest rates, helping to offset the stock market’s losses.
Rising interest rates are usually a sign that the economy is in good shape and getting better. In this scenario, stocks are doing well, but bond returns may suffer. Bond prices fall as interest rates begin to climb and expectations for inflation and further interest rates accelerate. This is the scenario we are seeing right now. Over the past year, the S&P 500 has done well, rising approximately 15 percent despite the recent correction.
So why did both your stocks and bonds drop during the recent stock market correction? Because this was not a typical correction. Corrections are usually prompted by fear that the economy is slowing. This tumble, however, was triggered by concerns that the economy is, well, too good — that the labor market is getting tight and inflation might be looming.
What’s more, as stocks were falling in a long-overdue correction, interest rates were making their own belated move upward with the 10-year Treasury spiking from 2.2 percent to approximately 3 percent. That interest rate rise also took a chunk out of prices in many bond categories. NOTE: I stress the word categories, as it’s important to remember that all bonds are not created equal. There are many unique and different bond categories, a vast continuum of maturity length, and credit quality.
In this recent and volatile window of time, stocks went down and bonds didn’t seem to help much. Does this confluence of events mean the stock-bond relationship is broken forever? No. I think that once interest rates get back to a more normal, historical level, the correlation will return. Remember, last fall the 10-year Treasury yield dropped to nearly 2 percent. That’s tremendously low over the course of history. We closed out this past week knocking on the door of 3 percent. So, rates have come up tremendously and might well continue to rise. Once interest rates normalize and the 10-year Treasury gets closer to 3.5 or 4 percent, this very useful inverse correlation will likely return.
Of course, as interest rates rise, bond prices won’t do wonderfully well, making this a tougher time for bond investors. I don’t love that, but I do look forward to a return to normalization in the stock-bond relationship.
Several callers to my show have asked if they need to find an alternative to bonds to diversify their portfolios. My answer to this query is no, as long as investors own bonds with relatively short-term maturities (in the one- to five-year range). Again, the recent bond market pullback was the latest unusual event in the very strange period that began with the great financial crisis. We saw a 10-year Treasury yield that for the past 30 years has historically hovered in the 4 to 6 percent range go all the way down to under 1.5 percent. But as the economy continues to show strength, interest rates are likely headed back to their historical norms. Again, this should return bonds to their traditional role in tamping down stock volatility in your portfolio.
Remember, the long view is critical to making solid investment decisions. Look beyond the recent correction and you will see that when it comes to the all-important job of diversifying your portfolio, bonds can still be a useful tool.
The original AJC article appears here.
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