Many investors are unaware of the role that bonds play in an investment portfolio. But most portfolios are a combination of stocks and bonds. In this post we will discuss the rationale for having bonds in our portfolio.
Content
- Introduction
- Comparison between Bonds and Stocks
- Diversification
- Why this Combination has worked so well since the 1980s
- The Future Role of Bonds in a Portfolio
- How to Add even more Diversification
Introduction
Before we dig into the role bonds play in an investment portfolio, it should be noted we will mostly be referring to government bonds. That is, bonds issued by governments without any risk of default, such as Germany, the United States, the United Kingdom or Japan. Such an analysis would be more complex if we had to take into account credit risk.
When analyzing how good an investment has been, many people look at its historical performance only. However, we must also consider the risk of that investment. Risk can be defined in many ways, but the most common ones are the volatility of the asset (i.e. how much it moves) and its largest percentage losses experienced.
And the lower the risk, the better for the investor. We want the highest returns, lowest volatilities, and lowest percentage losses.
Considering both return and risk is the right way to analyze investments. What would you prefer, an asset with an 8% guaranteed return, or an asset with a 9% expected return with risk of both higher gains and large losses?
Most people would go for the former. This is because that investment has a much better risk-reward profile. And understanding this will be important when we speak about bonds.
Comparison between Bonds and Stocks
When we compare stocks and bonds, stocks are expected to achieve higher returns in the long run. However, this is not always the case. For example, Japanese bonds have outperformed Japanese stocks since late 1980s and, similarly, European bonds have outperformed European stocks since the late 1990s.
When it comes to risk, stocks tend to be riskier than bonds. The stock market is very volatile and can suffer large drops. Bonds are fairly stable, though long maturity bonds can also be very volatile. However, bonds can be held until they mature, in which case price fluctuations can be ignored.
Let us use some example numbers to compare stocks and bonds.
When we invest in stocks, we do not know what returns we will get. We can look at historical data and see that the average annual return is 8%. We can also see that volatility is high, and we can expect a drop of more than 30% every 10 years, without knowing when.
On the other hand, we can invest in a bond with an interest rate of 4% and maturing in 10 years. Even though the price of the bond will fluctuate, we know full well today how much interest we will get every year and when we will get our principal back.
Diversification
If we combine stocks and bonds, we will have a portfolio with an average expected return between that of stocks and bonds, but its risk will be much lower than the average between stocks and bonds. Such is the power of diversification.
Diversification is about combining assets whose returns are not highly correlated. Meaning that, if one asset performs poorly, the other performs well.
The best way to look at this is by analyzing what returns we can expect from stocks, bonds, and a portfolio with 60% stocks and 40% bonds, in three different scenarios:
As you can see, stocks have greater potential but also higher risk. Bonds have less potential but are less volatile and can reduce the risk of our portfolio. A combination of both asset classes offers very the best risk-reward profile. This is precisely the role bonds play in a portfolio.
Why this Combination has worked so well since the 1980s
If you look at the table above, you will see why adding bonds to a portfolio has worked so well over the last 4 decades. Bonds tend to have great returns when there is a recession but suffer little when there is an economic boom. Why is that?
To understand this phenomenon, we need to understand how bonds work. The return on bonds can be divided between their interest (also known as their yield) and the price change of the bond.
The interest on a bond is known in advance. In our previous example it was 4%. On the other hand, the price change depends on the change in interest rates. When interest rates rise, the price of bonds falls. When interest rates fall, the price of a bond increases as its higher interest in now more valuable.
The following article explains in detail the relationship between the price of a bond and its yield (or interest rate):
Relationship between the price and yield of a bond
When there is a recession, the central bank lowers interest rates to “stimulate” the economy. As a result, bond prices go up.
When there is an economic boom, the central bank raises interest rates to combat inflation. Therefore, bond prices go down. But usually not by that much. Why? Because since interest rates peaked in the 1980s, they have been trending down. This means that interest rate cuts have always been larger than interest rate increases.
Continuously falling interest rates have had several consequences:
- The return on bonds has been extraordinary. Not only have investors collected high interest rates while holding them but, due to the continuous drops in interest rates, bond prices have appreciated dramatically.
- Falling interest rates have meant that, by comparison, stocks have become more attractive. Investing in stocks is much more attractive with interest at 3% than at 8%. This has helped stocks go up in price.
- The 60-40 portfolio (60% stocks and 40% bonds) has achieved spectacular results. Not only have we had the diversification benefit of combining stock and bonds, both asset classes have performed extremely well.
- Once interest rates started to increase in 2022, both stocks and bonds suffered. However, these price declines also made both asset classes more attractive going forward.
The Future Role of Bonds in a Portfolio
The inflationary wave of the early 2020s led central banks to start aggressively hiking rates in 2022 and 2023. We have witnessed the largest interest rate increases since the early 1980s.
As a result, both stocks and bonds have plummeted. In fact, it has been the worst year on record for the 60-40 portfolio. Never before had a diversified portfolio of stocks and bonds performed so poorly.
Nonetheless, this makes the case for adding bonds to our portfolio even stronger. During 2020 and 2021, bond yields were extremely low. This meant that the ongoing interest we got was tiny, and the potential for price increases very small.
But bond yields have climbed so much that they now offer both a higher interest rate for holding them and larger potential for price appreciation if central banks cut interest rates in the future. Additionally, since stocks have also become cheaper, they have also become more attractive.
In a way we could say that the role of bonds in an investment portfolio is the best it has been in the last 15 years.
How to Add even more Diversification
While stocks and bonds are the most popular combination in a portfolio, diversification can be further taken advantage of by adding other asset classes like gold and commodities to our portfolio.
This has the potential to improve the risk-reward profile of our portfolio even further, shielding it against more extreme macroeconomic and geopolitical scenarios.
If you would like to learn more about bonds, check out this section:
Bonds
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