At the start of 2018, we saw both bonds and stocks decline together. Diversified bonds lost around 2% at the same time that the S&P 500 temporarily lost around 10%. You may have read that much of traditional investment wisdom says that holding stocks and bonds together can help a portfolio. This is because bonds may rise when stocks fall and vice versa. So what happened early in 2018? Why didn’t this tried and tested strategy work?
Well, firstly, investing especially in the short-term is about calculated risks, not certainty. Historically stocks and bonds have worked well together, but bonds aren’t perfect in helping stocks. Very roughly bonds are helpful in stock market declines about half the time or more, but don’t offer certain protection. Just because bonds don’t appear to be working for a 2 week period this year, doesn’t mean that they aren’t useful for the longer term. What we saw over a brief 2 week period of time, shouldn’t inform our long-term strategy.
How stocks and bonds move, in part, depends on what ‘s prompting a market decline. Let’s keep things simple and assume markets can decline for two main reasons, either a fall in economic growth or a reduction in valuations:
Lower Growth – if there’s a recession (negative growth) that’s bad for stocks the process of growing sales goes into reverse, and typically company’s profits fall faster than their sales do. So, it’s common for stocks to fall in recession. Now, government bonds are largely unaffected by recession (or even rise in price if interest rates are cut, but we’re keeping things simple for now), and government bond coupons will more than likely still be paid even if corporate profits are down. So you can see that basically in a recession, bonds should hold up as stocks decline on growth fears, and that’s often what we see.
More Pessimistic Valuations – a second possibility for a market decline, is simply a reduction in valuations. For example, if the market was willing to pay 25x earnings for companies, but now wants to pay 20x, then stocks will fall. However, in this environment bonds may get hurt too. Maybe a 2% yield was acceptable before, but now investors are looking for 2.5% (bond prices fall when yields rise), hence bond prices decline – perhaps not as much, but still moving in the same direction as stocks.
What we may have seen in early 2018 was a reductions in the valuations people were willing to pay for financial assets, perhaps due to a reduction in easy money from expected raising rates, perhaps due to higher inflation expected down the road, or a combination of both. This scenario can help explain why sometimes stocks and bonds can fall in tandem.
It’s Easier In A Bull Market For Bonds
It’s also important to remember that in the 1980s the yield on the 10 year Treasury bond hit 15%. Let’s just pause for a second. Obviously hindsight is 20/20 but you could have earned 15% a year, just by clipping US Treasury coupons back in 1982. That same yield now down to under 3%. Today, even if you look overseas it’s hard to find that level of interest on government debt – Greek 10 year government debt yields 4%, Indian 7% and Brazilian 9%. It’s fair to say yields have come down a lot since the 1980s, they have dropped quite dramatically. The reason is that rampant inflation (price increases) are now under control in most parts of the world whereas in the 1970s and 1980s, inflation was a concern.
A reduction in yields for bonds raises their price. In this case, the drop in the 10 year yield from 15% to 3% caused the price of a generic government 10 year bond to more than double over time. Remember, of course, that that impact was spread over almost 40 years. Still, that’s a healthy tailwind for bond prices. We don’t know what the future holds, but clearly with yields at 3%, even if they fell to 0% (as currently the case in Japan) that would still be small price increase of around a 20%, relative to prices coming down from 15% to current levels when bond prices doubled or better. So, in part, bonds have risen over recent history because that’s the mechanical function of yields declining. It wasn’t that bonds were always rising in reaction to stock decline, but just that they were seeing a slow rising bond trend spread over decades. This means that bonds may offer less protection now, than in recent history to the extent there is less of a historical backdrop to promote rising bond prices.
What Does Protection Mean?
It’s also worth taking a step back and asking what protection means. It is never fun to lose money. Nonetheless, at a time when the market fell 10%, bonds fell 2%. It’s tempting to focus on direction and say they both fell together, but nonetheless, bonds fell materially less than stocks did. This is perhaps not what everyone would like in terms of protection, but still a far better outcome than holding stocks standalone.
Are There Better Sources Of Protection?
Bonds are traditionally a good way to protect a stock portfolio most of the time. It’s a little bit like insurance for your stock portfolio that also pays you money. This is because you receive interest payments for holding bonds. You expect that in a bad market there’s a good chance bonds rise, but you also get paid money to hold bonds. Other assets don’t typically offer that same level of reliability. For example, commodities can be on a different valuation cycle to stocks, and offer protection that way, but they are less predictable and don’t typically pay dividends in the same way bonds do. Equally, strategies such as owning put options can protect a portfolio, but if an option expires worthless, you lose all the money invested. Bonds on the other hand will likely preserve their value, even if their value as insurance isn’t needed.
What Does The Future Hold?
It’s probable that with yields lower than historically, returns for bond investors will be less attractive since the current yield is a good prediction of high quality bond returns. However, that doesn’t mean their role in smoothing a portfolio has ended. A portfolio that contained bonds had a much smoother ride in the market fall earlier this year, and that’s likely to be the case going forward if history is any guide.
