By Peter Westaway, chief economist and head of investment strategy, and Giulio Renzi-Ricci, senior investment strategist, Vanguard Europe.
The primary role of government bonds in an investment portfolio is not to drive returns but to act as a stabiliser.
It’s an important point to remember as we contemplate the broader potential fallout that might come if bond markets begin to reverse some of their strong performance of recent decades. So suggestions that the current bout of weakness in bonds should prompt a fundamental review of the place of fixed income in a portfolio are misconceived.
Thanks to the dependable income streams they offer, government bonds tend to be less volatile than shares. In the main, bond prices also move in the opposite direction to share prices, especially during periods of market turmoil.
So, historically, they have helped to keep portfolios on a relatively even keel by smoothing out returns — which is especially important if you are close to retirement or relying on your investments to cover your living expenses.
It’s why bonds provide clear diversification benefits and why we argue that the case for a balanced portfolio of stocks and bonds, including the classic “60/40” portfolio, remains intact. Our research has found this holds even when yields are negative. Whether yields are negative or positive, bond prices tend to rise when equities fall and this diversification benefit tends to come at the expense of foregone return. If an investor wants more return, they can get it by choosing a higher equity share and accepting higher portfolio volatility.
It is true that recent price action hints at a fundamental reversal of fortunes for bond markets compared with recent years when yields were consistently falling and the value of bonds therefore rising.
US 10-year Treasury yields
Source: Bloomberg, as of 15 March, 2021
The yield on 10-year US Treasuries — a bellwether for global bond markets — has risen by around half a percentage point since the start of the year. As well as dragging on other bond markets, it’s recently also knocked stock markets too, as concerns have grown over a possible rise in inflation and, by extension, interest rates. Investors seem worried about the potential fallout from excess policy stimulus and a post-pandemic consumer spending spree.
We recognise the risks of further sharp rate increases and even of higher inflation, but we also think such “bond vigilante” talk can be exaggerated.
It is, in any case, besides the point, because government bonds, for us, would most likely continue to be indispensable diversifiers in a balanced portfolio even if bond markets started to underperform. Even if bond prices fall over the next year, investors should continue to hold them because they will continue to provide effective insurance against stock market volatility.
Total returns from bonds, though lower than in the past, would also be likely to remain positive over the long term as cash flows from rising yields were reinvested.
The dynamics between stock and bond market returns are often complex, but so too is the relationship between interest rates, inflation, economic growth and corporate profitability.
Bond and share prices do sometimes fall at the same time, as we’ve seen recently and as we saw during the market slump of March 2020. In fact, when we looked at market data covering the 20 years up to that global pandemic sell-off, we observed that it had happened about 29% of the time.
However, this changes nothing, since bonds, on the whole, still behave differently to shares and continue to act as important shock absorbers in a multi-asset investment portfolio. On average, when equities performed very poorly (a price decrease of 10% or more from peak to trough), government bonds still helped to cushion the effects by returning positive returns. More severe equity downturns were associated with higher returns for bonds.
Notes: Equity returns are defined from the MSCI AC World Total Return Index and bond returns defined from the Bloomberg Barclays Global Aggregate Total Return Index, hedged to GBP. Both equity and bond returns are reported in GBP. A bear market is defined as a decrease of more than 20% from the previous maximum. Similarly, a correction is defined as a decline of more than 10% but less than 20%. The size of each circle is directly proportional to the number of calendar days that the period covers.
Source: Bloomberg, using monthly data from January 1988 to November 2020.
Our research shows that in instances where bonds and shares perform in tandem, the causes are overwhelmingly short-lived. But once markets are given enough time to factor in the monetary policy responses, we observe that the usual inverse relationship between bonds and shares is re-established. Indeed, our analysis of recent prolonged market downturns suggests the longer a crisis drags on, the more likely bonds play a stabilising role, and this includes recent episodes when rates seemingly had no further to fall1.
At Vanguard, we have been anticipating a low-return environment for some time. This does present a challenge but is not unique to the classic 60/40 portfolio of shares and bonds. Expected risk-adjusted returns are depressed for the full spectrum of investment strategies and we would be wary of any solution that promises an easy escape from this low-return environment via alternative strategies, such as real estate, which may appear to offer attractive returns but which come with additional liquidity risk.
Prudent portfolio construction is about striking the right balance between different types of assets that historically offer different levels of potential risk and return, and then diversifying these investments in line with an investor’s goals. With shares and bonds you can do this, and easily.
The further away a goal, the more an investor is able to tolerate market swings and, hence, invest in higher-risk shares, and the less bond exposure is required. The older people get, the more their time horizon narrows and the more urgent is their need for lower-risk stabilisers.
We don’t believe in one-size-fits-all solutions. Investors can dial up or down the risk-return profile of their portfolios depending on their investment goals, investment horizon, risk tolerance and a set of realistic expectations for asset returns (net of costs).
In a low-return environment, the solution is not about beating the 60/40 model, but about finding the right asset allocation that can give investors fair odds of achieving their goals in the most efficient way.
The last thing investors should be doing is to abandon the principles of good asset allocation. There isn’t a silver bullet alternative.
1 Renzi-Ricci. G and Lucas Baynes, "Hedging equity downside risk with bonds in the low-yield environment", Vanguard Research, January 2021.
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