Typically, investors hold bonds in their portfolio to
mitigate the volatility of stocks. While
bonds may reduce the portfolio volatility and drawdowns of a stock portfolio
somewhat, it would take an extremely large bond allocation, along with an
extremely large reduction in potential portfolio returns, to have any
meaningful impact.
Reducing Portfolio
Volatility and Drawdowns--The Traditional Approach
Very few investors can tolerate the volatility and drawdowns
of a portfolio that is 100% weighted towards stocks. From October 2007 to March 2009 a portfolio invested solely in
the S&P 500 would have endured a 60% drawdown. Not many people could endure that kind of
loss without selling in a panic. Bonds
are often not correlated with stocks, especially during market downturns, and
they typically are not subject to the same magnitude of drawdowns that stocks
are (depending on the type of bond of course).
In this case, adding bonds to a
portfolio would likely reduce volatility while also reducing returns. For example, in 2008 the S&P 500 Index
dropped 37% while the Barclays Aggregate Bond Index ETF (AGG) increased
7.57%. An investor who had a portfolio
that was 60% in the S&P 500 and 40% in the AGG would have lost about
20%. This is better than losing 37% but
it is still an unacceptable loss. During
up years for the market this same investor is likely to give up a lot of market
upside for not much protection on the downside.
Investors will often think of bonds as risk free or near
risk free. Bonds have been in a bull
market (caused by a steady decline in interest rates) since 1982, this covers
the entire investing experience of most investors today. If they have never seen a bear market in
bonds they start to believe that it can't happen. Bond prices move inversely with interest
rates, if interest rates rise then bond prices will go down. Nobody can predict whether interest rates
will rise in the future but common sense suggests that they will. The Federal Reserve has been artificially keeping
rates low since the 2008 crisis, this will not last forever. Traders also make decisions on whether to
allocate money to stocks vs. bonds based on risk and return. In times of high interest rates and/or
financial crisis, traders move money to bonds.
In times of low interest rates and rising stock prices, money flows to
stocks. As the stock market continues to
recover from the 2008 crisis, more and more money will flow out of bonds,
causing prices to go down, and into stocks.
Bonds can also decline in value for other reasons besides
interest rates. Higher yielding areas of
the bond market, such as high yield and emerging market bonds, had drawdowns of
25%+ during 2008.
Reducing Portfolio
Volatility and Drawdowns--The TTM Approach
Instead of having a fixed allocation to bonds that
could-----decrease portfolio drawdowns somewhat, decrease portfolio returns,
and lose value when/if interest rates rise----we maintain a tactical
allocation. When our momentum measures
show that bonds are stronger than stocks this indicates that the risk of a
decline in stocks is high and the potential rewards are low. In this instance we can shift all the way to
100% in bonds. Not only would this
enable us to reduce drawdowns substantially during bear markets, it also allows
us to potentially make money in a market downturn. When momentum shifts back towards stocks it
indicates that the potential rewards in the stock market are high and the risks
of a decline is not as high. In this
case we can move out of bonds and go to 100% stocks, avoiding the drag on
portfolio returns that comes from owning bonds.
If our momentum measures favor bonds over stocks, then a
decision must be made about which bond sector(s) we should allocate to. Typically, we only use bond sectors that are easy
to buy and sell through actively traded ETFs---investment grade corporate, high
yield corporate, emerging market, Barclays Aggregate Bond Index, Treasury
Inflation Protected Securities (TIPs), and/or Treasury Bonds. During times of great market turmoil,
Treasury Bonds tend to be the best bond sector as traders prefer the perceived
safety of Treasuries, regardless of interest rates, to the risk of stocks.
At some point the bull market in bonds will end---for it to
continue interest rates need to decline from here which is possible, but not
likely. Once it ends, investors that
have fixed allocations to bonds will suffer losses. Until it ends, it is likely that bonds will
drag down portfolio returns as a major part of their return comes from interest
rates, which are currently low. By using
bonds tactically to hedge whether they are in a bull or bear market is irrelevant. Regardless of the level of interest rates
bonds are a safe haven at times of turmoil in stocks. Investors are willing to earn very little, if
anything, in bonds to avoid potential losses in stocks.
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