[ad_1]
Many investors forget that there is more to investing in bonds than yield and income.
If that was the only reason, investors could be excused for wanting to cut their bond allocation right now – if not eliminate it altogether. With bond yields at all-time lows on a nominal basis, and even lower (if not negative) on an inflation-adjusted basis, it’s hard to see how bond investments will produce any big profits over the next several years.
But there is another major reason for investing in bonds, which is to reduce the volatility of an all-equity portfolio. And the last century shows that this capacity to amortize bonds is in fact greater when interest rates are lower.
From this second perspective, investors might even wish to celebrate today’s lowest rates. Rather than heralding the death of the 60/40 equity bond portfolio, the low rates may be a reason to step up commitment to portfolio diversification.
The graphic below provides the historical basis for this view. It shows for each month since 1926 the correlation of stocks and bonds over the following 120 months. The graph also plots for each month where the yield of the 10-year Treasury was. Note that the two sets of data tend to rise and fall in unison, with higher Treasury yields coupled with higher stock-bond correlations over the next decade.
To understand what this means for your portfolio, remember that lower stock-bond correlations are more beneficial. This is because it means that bonds are more likely to rise when stocks fall. Higher interest rates are therefore a double-edged sword. While they mean that bond investments will produce a higher nominal return, these higher rates also mean that a portfolio of equity bonds will not be as risk-free as it would have been if rates had been. low.
Other factors to keep in mind
Needless to say, this is not the final world on the subject. Researchers have comprehensively analyzed the correlation between stocks and bonds over the decades and have discovered other factors that influence it besides the level of interest rates.
A useful introduction to these other factors is an article published many years ago in the Fixed Income Journal, entitled “Equity-bond correlations”. Its author was Antti Ilmanen, now Global Co-Head of the Portfolio Solutions Group at AQR Capital Management. He identified several additional factors to keep in mind when trying to predict whether the stock-bond correlation will be high or low. These include:
-
Faster than expected economic growth will lead to a weak or even negative correlation. This is because stronger growth will help stocks and hurt bonds.
-
Higher than expected market volatility will also result in a low correlation between stocks and bonds, as this volatility will hurt stocks and help bonds (due to a flight to quality away from stocks).
-
Changes in monetary policy and expected inflation, however, will cause the correlation between stocks and bonds to increase.
So, if economic growth will be faster than expected in the coming years, or if stock market volatility will be higher than currently expected, then the equities-bond correlation should decrease. If there is an unexpected tightening of monetary policy in the coming years, and / or if inflation is unexpectedly higher than currently expected, then the equities-bond correlation should increase.
As always, nothing is guaranteed in this business. But low interest rates are not, in and of themselves, a good reason to abandon a diversified portfolio of equity bonds.
Mark Hulbert is a regular contributor to MarketWatch. Its Hulbert Ratings tracks investment newsletters that pay a fixed fee to be audited. It can be reached at [email protected]
More: Burton Malkiel investing legend on day-trading millennials, the end of the 60/40 portfolio and more
More: GMO warns of ‘lost decade’ for 60/40 wallets, sees echoes of 1999
[ad_2]
Source link