What’s going on with bonds right now? As we’ve discussed before, it’s a challenging year for bonds, but you might be surprised to learn that the death of bonds has been greatly exaggerated.
For context, we absolutely expect bonds to return less than stocks in the long run. From 1926 until the end of 2021, large cap US stocks returned over 10% a year, while a 5 year government bond index returned about 5%. Compounded over time, that is a massive difference.
Why would we want bonds at all? They have two advantages over a 100% stock portfolio that you should care about- they are somewhat uncorrelated to stocks, and they have less volatility.
Things that are uncorrelated don’t automatically move in opposite directions- that would be negative correlation. With uncorrelated assets, the movement of one has no impact on the movement of the other one. This is something very desirable since you don’t want everything in your portfolio going down at the same time.
Less volatility is also very much a good thing, meaning generally that bonds tend not to fluctuate up and down as much as stocks. This year is a great example- the Bloomberg US Aggregate Bond index is down about 10% at this writing. That’s one of the worst years on record for bonds, but it would only be a middlingly bad year for stocks. But isn’t this year a bad year for stocks too? Let’s review the big picture.
For a retiree, one of the worst things that can happen is a large portfolio drawdown in the years just before and after retirement. A crash just before retirement might force a delay to retirement plans. Worse, a crash just after retirement could dramatically change retirement lifestyle as assets are spent down while their prices are depressed.
We tend to allocate more to bonds around retirement because our best hope is that in a stock market downturn, bonds will likely either go down less or even go up some.
You might be surprised to learn that the idea is working, even this year. Looking at our Telarray portfolios, and also target date portfolios from several major fund families, allocations with more bonds are performing better than allocations with more stocks. Bonds are down, but stocks are down more. Bonds aren’t experiencing tremendous outperformance- it would be nice if they were actually flat or up this year- but there’s no doubt that if you had a crystal ball and allocated more to bonds at the beginning of 2022 you would likely be better off than being 100% stocks at this moment.
Of course, we have no idea what direction bonds (or stocks) will go from here, at least in the short term. In the long term, we are optimistic about seeing returns of stocks and bonds in line with historical experience. We are also optimistic that in the event of a more intense stock market correction, bonds will likely perform even better in the likely flight to safety reaction of market participants.
As bond prices have fallen, bond yields have risen to a more attractive level, which is another silver lining in this challenging year. One of the biggest complaints is that bonds have had “no yield” for quite some time. With bond yields higher and inflation on the way down, we could be set up for a period where bonds provide a meaningful source of real return in addition to their ability to dampen stock market declines.
In short, 2022 has been a challenging year for bonds and stocks, but bonds continue to fulfill a very important role in Telarray portfolios.