It’s easy to get sidetracked by the ups and downs of the market, but before you act, now may be a good time to review why you own bonds in the first place.
Since late February, U.S. equity and bond markets have been historically volatile—on the same level of the 2008-2009 Global Financial Crisis in fact. In March, we saw the fastest bear market correction in the S&P 500 Index on record. Rates are hovering around all-time lows, the U.S. Federal Reserve cut short rates to zero, and global governments have enacted massive stimulus plans to try to alleviate some of the economic pain. From both a human experience and capital markets perspective, these are truly unprecedented times.
For bond investors, this seismic shift in the markets can create an immediate urge to act, and quickly. But before acting, I believe it’s best to pause and ask yourself, why do I own bonds?
Investors I talk to point to three key reasons:
1. Diversify equity risk
The importance of equity diversification has taken center stage over the past several weeks as the S&P 500 has entered a bear market. The logic behind diversification is that most investments don’t move together in the same direction at the same time. If an investor holds different types of investments, their gains and losses can potentially offset each other and make the investment experience smoother. If you take the S&P 500 to represent the stock market and the Bloomberg Barclays Aggregate U.S. Bond Index for the bond market, it’s easy to see that stocks and bonds tend to have an inverse relationship. Their correlation over the past 10 years has been close to zero—meaning stocks and bonds generally go their own ways. And that’s a good thing, because it’s less likely that stocks and bonds in a portfolio both go down in price at the same time. Hence, returns would be less volatile over time.
Investors can clearly see diversification in action when equity markets are down and bond investments are there to potentially provide stability to the portfolio.
The below chart compares core bonds (represented by the Bloomberg Barclays Aggregate U.S. Bond Index) against the S&P 500 during previous periods of equity market downturns, including the start of the COVID-19 crisis. As you can see, core bonds have been a strong hedge against equities during these stressed events.
Why? When stocks fall, money often moves from stocks to bonds—so called “flight to quality”—pushing bond prices up. Prices tend to go up more for bonds with higher levels of interest rate risk. For this reason, fixed income investments that have medium to high levels of interest rate risk provide better diversification to equities than investments with low levels of interest rate risk. This is a very important point, and one that is often missed by investors: If you hold bonds to diversify equity risk, you want interest rate risk.