The recent bond sell-off has been tough and emotional reactions to it are understandable. After all, the first and second quarters of 2022 were the Bloomberg U.S. Aggregate Bond Index’s third- and fourth-worst since inception (the only two worse performances happened a long time ago, both in 1980).
You might be wondering whether bonds still deserve a place in your portfolio. Here are two reasons they do.
Bonds provide diversification benefits
There has been a rout recently in bonds, but stocks are still much more volatile overall. While a double-digit peak-to-trough drop of around 14% in U.S. bonds (as measured by the Bloomberg U.S. Aggregate Bond Index) is newsworthy, the S&P 500 Index (which represents the largest U.S. companies) has had much larger independent drawdowns of 55% during the global financial crisis, 47% during the bursting of the tech bubble in the late 1990s, and 34% during the early days of COVID-19. Even now, U.S. stocks are notably under their prior peak.
As is the case whenever a particular asset class suffers through a choppy period, it’s tempting to think about selling out and putting that money to work elsewhere (in this case, perhaps reallocating to stocks or moving to cash).
But abandoning bonds in favor of stocks is risky. And abandoning them in favor of cash (which has less interest rate sensitivity) comes at the cost of lower returns. Bonds offer a risk premium that allows them to outperform such assets over time, often even as interest rates rise.
Here are some things to consider before making changes to your asset allocation:
- A dollar invested in stocks is typically exposed to three to five times more risk than a dollar invested in bonds.
- The return experience of a balanced portfolio (composed of 60% stocks and 40% bonds) is almost entirely dependent on stocks.
- Historically, in months when stocks were down, a balanced portfolio was also down—more than 90% of the time.
- On the other hand, in months when bonds were down, the portfolio was more likely positive than negative. Bonds hardly contribute to overall risk in a 60/40 portfolio.
Short-term pain…long-term gain?
While rising interest rates can be painful in the short term for bond investors, the resulting higher bond yields should eventually translate into higher bond income and returns. The Federal Reserve has moved from cutting interest rates to raising them—a necessary action to combat inflation, but one that may well lead to recession. If that happens, yields will probably fall as the Fed begins to cut rates again to achieve economic stability. Even if a recession never happens, bond performance should still improve as long as inflation drops and rates remain steady.
Sharp sell-offs in both bonds and stocks happening at the same time are also hard to swallow. It may help to temper expectations: while bonds remain one of the only true diversifiers to stock risk, there is still a positive correlation between the two asset classes. That means that sometimes, they will rise (or fall) simultaneously.
If you need help deciding whether or not your portfolio aligns with your goals, we invite you to get a free opinion from one of our advisors.