With investment-grade bonds in the red this year and yields at dismal levels, many financial advisors are considering reducing their clients’ allocations to this asset class. But before acting, you should consider the important role that bonds play in risk mitigation within a balanced portfolio.
High-quality bonds, particularly government bonds, bring a vital diversification effect to equities risk. In the U.S., since 1926, the correlation between intermediate government bonds and the S&P 500 composite index has been a negligible 0.07. Government bond and stock returns, on average, tend to rise independently.
The real diversifying power of bonds is evident in the correlation pattern. During bull markets, the correlation is mixed. However, during most bear markets and, in particular, the steep market declines of 1929-32, 1973-74, 2000-02 and 2007-09, the correlation between government bonds and stocks went strongly negative. Bond prices typically go up when stock prices plunge.
For many clients, the acid test for a portfolio is its drawdown characteristics. Since December 1979, a portfolio comprising 100% of equities, split equally between the S&P/TSX composite, the S&P 500 and the MSCI EAFE indices experienced nine drawdowns in excess of 5% – with an average decline of -20.5% and a maximum decline of -41.9% (in Canadian dollars; at monthend). In contrast, a portfolio of 50% bonds (DEX universe index) and 50% equities experienced nine drawdowns – with an average decline of -10.4% and maximum decline of -19.4%. The 50% bond allocation cut downside risk in half.
There also is a difference in the duration of the typical decline and recovery cycle. The 100% equities portfolio had an average decline and recovery duration of 26 months; the 50%/50% bond/stock portfolio, 15 months.
No other asset class can fully replace bonds’ diversification role. Gold has a similar average correlation with equities. However, gold’s diversification impact during bear markets has been more uneven and its performance is much more volatile. Gold also is subject to longer, deeper drawdowns and does not have any income yield.
High-dividend paying stocks are not the solution. The MSCI Canada and the world high-dividend yield indices suffered drawdowns of -42.5% and -49.9%, respectively, during the credit crisis. Since January 1999, the volatility of the MSCI Canada high-dividend yield index, as measured by standard deviation, has been 14.2%, almost four times the 3.8% of the DEX universe bond index.
Hedge funds also are not a complete substitute. The Scotiabank Canadian hedge fund index declined by 26.7% in 2008. And managed futures and well-managed market-neutral strategies did much better but bring other risks into a portfolio.
High-quality money market instruments offer downside protection and lower volatility. However, they have reinvestment risk, offer a lower expected long-term return than bonds and are a much poorer deflation hedge.
You can reduce reliance on bonds somewhat by making modest allocations to these other asset classes. But quality bonds still are needed to mitigate equities risk.
Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm.
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