Part I: Bonds
- Conventional wisdom is that bonds always protect portfolios from stock declines.
- This would require a strong negative correlation between stocks and bonds.
- Evidence suggests:
- The stock/bond correlation is small and may even be slightly positive.
- Bond returns can be negative even when stock returns are negative.
- Rising interest rates reduce bond prices and affect bond returns negatively.
- Rising interest rates can also affect stock returns negatively.
- However, other factors also affect stock returns. Hence the minimal correlation.
- Even though stocks and bonds can decline at the same time, the limited stock/bond correlation means that holding bonds can still offer substantial diversification to your portfolio.
The first half of 2022 delivered very poor investment returns. Stock returns were negative across the board. The broad US stock market Russell 3000 index and the world stock market MSCI All Country World Index Investable Market Index (ACWI IMI) index both declined more than 20%, and the NASDAQ index, which emphasizes technology stocks like Amazon
Stock returns over the past 5 years, even allowing for the disappointing results of the last two quarters, have been very positive. The broad US stock market Russell 3000 index returned about 10% per year, the world stock market MSCI ACWI IMI index returned about 7% annually, and the NASDAQ index generated 16%. Bond values also increased (although not nearly as rapidly), with the broad US bond market Bloomberg Aggregate returning about 1% per year, and the TIPS index and short-term TIPS both returning about 3% annually. In other words, we can usefully think of the first six months of 2022 as ‘giving back’ some of the favorable returns of the prior four and a half years.
But why did stocks and bonds decrease in value?
That said, many investors were most concerned about the simultaneous decline in stocks and bonds. We tend to think about bonds as safe investments, protecting us from the volatility of stocks. Our reading of investment websites (and perhaps what we remember about that reading) tends to encourage that view. In fact, however, as the box below (drawn from Fidelity’s website) emphasizes, bonds often, but not always behave differently than stocks.
Historical evidence reinforces the point. We have 46 years (1976-2022) of data on the Bloomberg US Aggregate Bond Index. Examining stock (S&P 500) performance in comparison, we see that stocks and bonds have moved somewhat differently. The column on nominal returns reports what you’d see on most websites and in most annual reports.
Stocks and bonds moved in different directions about one third of the time, and both rose nearly three times out of five. That still leaves nearly one quarter out of every 10, or 1 every 2.5 years, when both stocks and bonds were down. Adjusting for inflation (the Real Returns column) suggests that the ‘protective effect’ is even weaker, with bonds and stocks both down approximately one quarter out of six, or about once every year and a half. Statistically, stock and bond returns show at most a weak correlation. There is little reliable relationship between the returns of stocks and bonds in these nearly 50 years of data.
That suggests at least two questions:
- Why aren’t stock and bond returns more correlated?
- Does including bonds in a portfolio still reduce its risk even if bonds aren’t negatively correlated with stocks?
The first question is very complicated, but we can go a long way toward understanding it without getting into too much detail. The answer to the second question is YES, and I’ll provide a simple illustration to show why that’s true.
Bonds and stocks are both securities. They both offer the prospect of future income, and both have a cash value that investors can realize whenever they choose.
What About Bonds?
As the table suggests, the surface similarities of bonds and stocks camouflage deep differences, however. I’m not attempting to list all the risks. Otherwise, just like in a prospectus, we’d have to use extremely thin paper.
Bonds are loans, incorporating promises which support cash flow predictability and investor confidence. The major risks are changes in interest rates, which the bond issuer cannot influence, and reductions in the issuer’s ability to keep its promises to pay interest and repay principal. Changes in interest rates change the present value of a bond’s cash flows, and thus the bond’s price, even though the cash flows themselves haven’t changed. If the issuer can’t keep its promises, the cash flows themselves decline. Inflation is also a risk, for stocks as well, deserving a discussion all its own. I’ll cover that another time.
Let’s look at an example, a hypothetical $1,000 5-year bond paying 5% interest. The buyer of the bond expects to receive $50 interest at the end of each year and return of the $1,000 principal at the end of the fifth year. The graph below illustrates these cash flows.
If we simply add up the cash flows, we get five $50 coupon payments or $250 plus the $1,000 principal payment for a total of $1,250. But the bond sells for $1,000. That sounds like an opportunity to get “free money.” If we recall that the interest rate is 5%, we can resolve the apparent contradiction. With positive interest rates, a coupon payment in the future is worth less than a coupon payment today.
Each interest rate implies a series of “present value factors” translating future cash flows into current values. For example, the 5% interest rate means that a payment of a dollar at the end of the first year is worth $.95 (95 cents) today – see the chart below. At 7%, that payment at the end of the first year is worth $.93 (93 cents) today.
Applying those present value factors to the bond’s cash flows, we can calculate:
- At a 5% interest rate, the bond is worth $1,000.
- At a (higher) 7% interest rate, the bond is worth $918. This illustrates the potentially puzzling fact that when interest rates rise, bond prices fall.
- Also, higher interest rates have a larger impact on bonds with longer maturities – visually, you can see that present value factors decline more for later cash flows (compare present value factors for 5% and 7% for five years to those for one year)
Finally, if the issuer finds itself in financial distress, and announces that it can pay only 60 cents for every dollar it owes (this 40-cents per dollar / 40% reduction or “haircut” is a realization of credit risk), the bond is worth $600 at the 5% interest rate. $600 is 60% of the bond’s issue price.
Why did bonds go down? Interest rates rose. The graph shows that interest rates for Treasury bonds with maturities from 5 to 30 years all went up 1% or more. That was true for both regular Treasury bonds and for TIPS, which are inflation-protected.
In the next article, we’ll look at why stocks declined, and in the third, we’ll explore whether bonds are still a useful source of diversification.
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