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Wednesday, November 5, 2014

The Most Important Thing About Bonds That Most Investors Don't Know

Not a bad hedge!
I've recently read a couple of books about bonds along with an article about how to protect a portfolio from a stock market correction.  The article was one of those Yahoo! type articles touting something like 10 ways to protect your portfolio.  It listed a number of esoteric ideas including puts, stop loss orders, etc. Nothing about bonds.  Maybe bonds wouldn't be your first thought either.

Maybe they should be.

Let's cut to the chase and take a look at the four times out of the past 20 years that the large cap core index, essentially the S&P 500, has produced a negative annual return along with the return on the Barclay's Aggregate Bond Index:

Large Cap Core Stock Index
Barclay’s Aggregate Bond Index

 Source:  BlackRock Asset Class Returns

Hopefully something jumps out at you.  The fact is that bonds, as the table clearly shows, offer a pretty decent hedge, i.e. insurance, to dampen the impact of stock market downturns.

People many times want to get wrapped up in the mathematics and look at correlations which, essentially, are fancy averages; but there is more to it than this.  I say this because most correlations disappointed investors in 2008.  Asset classes that were supposed to provide a cushion in the event of a downturn didn't.

Bonds, on the other hand, especially Treasury notes and bonds which comprise most of the Barclay's Bond Index, are the go-to asset when investors get scared!  This is called "flight-to-quality."

Understanding a bit of history can lead to a pretty good idea of how bonds will act in various scenarios. Is it possible for both bonds and stocks to have a negative return?  Surely, especially when inflation picks up.  Most likely, in this situation, if stocks drop (which is not a given), it won't be by much.  On the other hand, if there is a major downturn, 15% or more say, it is probably because  the market is scared and bonds could be expected to do well.

One point worth emphasizing is that fixed income encompasses money markets, certificates-of-deposit, and savings accounts.  Sometimes people treat these as bond like instruments.  They are not.  Their price won't rise in a "flight-to-quality" instance.

What About Levels?

Most of the bond market has fixated over the past few years on the historically low rates and the need to position portfolios for a rise in rates.  After all, the thinking has been there is nowhere to go but up. Well, time has proven that this isn't exactly the case.  But beyond that, where should bond investors be today?

Well, if they load up on short duration bonds and corporate bonds offering higher yields, they could be severely disappointed in a crisis.  For example, if the market became convinced that we were locked into a serious Japanese-type deflation episode, the meager 2.35% 10-year Treasury yield could look robust.

The bottom line is that investors need to recognize that hedging like, insurance like, properties of bonds when managing their portfolios.  When is more the question rather than if when expecting a stock market correction?  When it comes, investors will appreciate their bonds (pun intended).

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