In recent years, investors around the world have become accustomed to very low interest rates. Bond yields were already low by historical standards at the beginning of 2020, but then the economic shock caused by the Coronavirus pandemic, as well as aggressive monetary policy responses from the world’s major central banks, combined to drive down interest rates even further across the entire fixed income landscape. Consequently, bond yields have plunged, once again, to all time record lows. This is great news for borrowers, but not so great for income investors. “Real” yields, which are yields adjusted for inflation, are now negative on cash holdings and on most government bonds around the world. For the first time ever, yields on investment grade corporate bonds have fallen to the same level as the dividend yield on the S&P 500. Investors in today’s topsy–turvy world can make an argument for buying stocks for the income and bonds for capital gains!
Given today’s unattractive yield environment, is there any reason why investors should continue to hold bonds in their portfolios?
Before we tackle that question, we should acknowledge that investors have been asking this very same question for the past decade or more, always believing that yields could not possibly go any lower. Time and time again, many retail and professional investors made the mistake of assuming that the long bull market in bonds must be over. Those that ignored the “warnings” and held on enjoyed significant capital gains on their fixed income investments, as yields continued to grind lower year after year. This is a great lesson on the nature of unpredictable financial markets – timing them is incredibly difficult, especially when markets do something unprecedented, as they are prone to do.
As to the question of maintaining an allocation to fixed income, we should remember that there are several reasons to hold bonds in a portfolio; current income is only one of them:
(1) Bonds are far less volatile than stocks and serve as a powerful risk reducer when added to an equity portfolio.
(2) Bonds are not highly correlated with stocks, and often move in opposition to equity investments. Thus, they are effective agents of diversification as well.
(3) When stocks experience a correction, as they do frequently, bond holdings can be used as a source of funds for rebalancing back into equities at lower prices. This helps to maintain your target portfolio allocation and allows mean reversion in prices to improve overall returns.
(4) Because interest payments and final maturity values are fixed, bonds protect the portfolio against the risk of deflation, which has historically impacted equity returns negatively.
(5) Bonds provide a low-risk, stable income to yield seeking investors.
All five reasons to hold bonds remain true today, although now that yields on short-term, high-quality fixed income are below the rate of inflation, risk-averse investors have been forced into making a tough choice between safety of principal or positive real yields. They can no longer have both at the same time.
But as the list above shows, while yields may be disappointing, bonds continue to offer powerful risk reduction and diversification benefits. In fact, evidence from the post-1999 Japanese experience with ultra-low rates suggests that bonds retained, and actually strengthened their role as diversification agents when rates approached the zero bound. Even in the absence of positive, inflation-adjusted yields, bonds continue to serve a vital role in well-diversified, efficient investment portfolios.
Source: https://mailchi.mp/verdadcap/asset-allocation-beyond-the-zero-bound
