Conventional wisdom says bonds zig when stocks zag, smoothing out volatile periods for investors with blended stock-and-bond portfolios.
Yet, last year that didn’t happen. Corporate and government bond indexes dipped with stocks, raising the question: “What good are they, really?”
To answer that, let’s explore some basics – what bonds actually do in portfolios and what makes them tick.
First: Bonds are simply loans. Buying a bond from a government or company means they borrow your money for a fixed period, promising to pay regular interest, and repay your principle at the end. In between, the bond’s value will fluctuate.
Second: Interest rates underpin those fluctuations. Bond prices and interest rates sit on opposite ends of a seesaw. When rates rise, bond prices fall – and vice versa. Pretend you own a Treasury bond paying 2% and maturing in 2029. If 10-year Treasury rates subsequently rise to 3%, your bond’s price will decline. Fewer people want to buy it when they can get a 3% interest rate. But, if 10-year Treasury rates instead fall to 1%, your higher-yielding bond becomes more attractive – its price will rise.
Third: For long-term government bonds, the main interest rate driver is future changes in inflation expectations. When everyone expects faster inflation, they’ll demand higher interest rates to offset it.
Corporate bonds have more variables, including the company’s changing creditworthiness and growth prospects. These will influence its ability to repay you later on. In this way, corporate bonds’ and stocks share some similarities – your first clue they don’t always move oppositely. More mathematically, consider correlations: They measure how closely related two assets’ movements are. Identical movement score is 1.00; exact opposite is -1.00. What’s the correlation between stocks and seven- to 10-year corporate bonds? It’s -0.01. That’s almost exactly midway. In other words, corporate bonds zig with stocks almost exactly as often as they zag against them.
Even Treasurys move with stocks more often than commonly thought. Why? Because a “Goldilocks” economy with moderate growth and low inflation, like now, keeps a lid on interest rates. Their correlation with stocks: -0.28.
Fourth: While the zig-zag effect of bonds helps sometimes, it isn’t what makes them helpful for blended portfolios. What is? Said simply, their wiggles, both up and down, are smaller. If you’re taking big cash flow from your retirement investments, this can be a big deal.
Fifth: The sharp ups and downs stocks bring can make cash flow-planning difficult. A slug of bonds dampen the swings somewhat. The relatively smoother ride means modestly lower long-term returns than 100% stocks. But that trade-off may be worth it for those relying on their investments for living expenses.
Regardless, growth remains important to offset inflation and generate enough future wealth to prevent you from running out of money. So owning too much in bonds becomes hugely risky for those with long future needs. But dampening volatility really does benefit those with shorter time horizons.
From this standpoint, bonds “worked” last year. They fell, but markedly less than stocks. That cushioned the blow somewhat for investors who owned both, while interest payments helped fund folks’ cash flow needs. The Standard & Poor’s 500 fell 4.4% last year, but a broad gauge combining U.S. corporate and government bonds fell just 0.8%.
Finally: Bonds can rise in basic value. Like stocks, bonds have enjoyed a V-shaped recovery so far this year, thanks to falling long-term interest rates and easing recession worries. Corporate bonds have done particularly well, and their bounce likely slows now. But benign long-term interest rates and strong overall corporate fundamentals point to a fine year for the category overall.