Why Bonds Still Matter
Do bonds still provide adequate diversification? That was the question many investors were asking in March 2020 when bonds and stocks sold off at the same time—before the Federal Reserve stepped in to calm markets.
In fact, some have gone so far as to proclaim that the “traditional” portfolio of 60% stocks and 40% bonds is no longer optimal. We believe such concerns are overblown for three reasons:
- Even when offering very low yields, intermediate-term U.S. Treasuries generally have held their value or appreciated during significant stock market declines—a trend that was borne out amid last year’s turmoil. On the other hand, short-term Treasuries—which are considered a cash equivalent—have failed to provide a similar hedge (see “A port in the storm,” below).
- Despite the blip last spring, Treasuries continue to demonstrate negative correlation with stocks over the short and medium terms, helping cement their status as a safe haven during times of market stress—and there’s no clear alternative to fill that role.
- The 60/40 split was never right for everyone, since the right mix of asset classes for your particular portfolio has more to do with your specific goals and capacity for risk.
A port in the storm
Over the past 30 years, intermediate-term Treasuries have provided a better hedge against market declines than short-term Treasuries.
Source: Schwab Center for Financial Research, with data from Morningstar. Intermediate-term Treasuries are represented by the Ibbotson U.S. Intermediate-Term Government Bond Index and T-bills are represented by the Ibbotson U.S. 30-day Treasury Bill Index. Dates represent the start of commonly accepted bear markets (periods during which the S&P 500® Index declined at least 20%), plus September 2018 (when the S&P 500 fell 19%). Past performance is no guarantee of future results.
Diversification benefits aside, the high returns seen from intermediate Treasuries last year aren’t likely to be repeated over the next few years. Starting yields for fixed income investments are a reliable barometer of future returns over the long run, and bond yields are currently near or at historic lows.
However, we do see the potential for 10-year Treasury yields to rise to the 2% level in the coming months—even as the Fed keeps short-term interest rates near zero—assuming the economy continues to recover. Consequently, we suggest reducing the overall duration in your portfolio to mitigate the risk of rising long-term interest rates, while maintaining an allocation to intermediate-term bonds for their diversification benefits. (Duration is a measure of the sensitivity of bond prices to changes in interest rates.)
Indeed, you might consider holding a mix of short- and intermediate-term bonds to manage the effects of rising interest rates. Short-term bonds provide the flexibility to reinvest if rates rise, while longer-term bonds provide stable yields that can help offset the effects of another round of market turmoil.
Alternatively, you could use a bond ladder—a portfolio of individual bonds or certificates of deposit that mature at regular intervals—which also allows you to reinvest the proceeds from maturing bonds in higher-yielding bonds once interest rates move up.
If the traditional 60/40 stocks-to-bonds allocation isn’t optimal, what’s an investor to do? For one, make sure your portfolio allocation matches your risk tolerance and goals rather than a supposedly one-size-fits-all target allocation.
Beyond that, we suggest broader diversification across all asset classes, not just bonds. Our anticipated returns for both bonds and stocks are lower for the next 10 years than over the past 50 years, due in part to high starting valuations and low inflation projections (see “Lower your expectations,” below). As a result, we suggest exposure to a wide array of global asset classes to help manage risk and provide a broader set of investment opportunities.
Lower your expectations
Returns for all asset classes are expected to be lower over the next decade.
Source: Charles Schwab Investment Advisory and Morningstar Direct. Data as of 03/31/2020. Indexes representing the investment types are: S&P 500® Index (U.S. large-cap stocks); Russell 2000® Index (U.S. small-cap stocks); MSCI EAFE Index (international large-cap stocks); Bloomberg Barclays U.S. Aggregate Bond Index (U.S. investment-grade bonds); and Bloomberg Barclays 1–3 Month U.S. Treasury Bill Index (cash investments). Past performance is no guarantee of future results.
Within fixed income, we still believe most investors should allocate the bulk of their portfolios to what we consider “core” bonds (think Treasuries and highly rated corporate and municipal bonds) for stability and capital preservation—but also include exposure to riskier investments like emerging-market bonds, high-yield corporates, and preferred securities, assuming you can tolerate the higher volatility that typically accompanies them.
And while we don’t expect inflation to be a significant problem over the next few years, we believe holding some inflation-linked bonds, such as Treasury Inflation-Protected Securities (TIPS), makes sense, to mitigate the risk of an unexpected spike in inflation.