In this era of exceptionally low and likely rising interest rates, many return-seeking investors are questioning the role, or even the very existence, of bonds in their portfolios. Indeed, the most commonly used broad market bond index, the Barclays U.S. Aggregate Bond Index, posted a -2% return in 2013[1], its worst annual result since 1994. However, we believe investors’ myopic focus on one, relatively small negative number may distract them from the primary reasons they bought bonds in the first place: diversification and low volatility.

There are really only two free lunches in the investment world: the magic of compounding rates of return, and diversification. Of course, now we must watch the shifting sands in Washington, D.C. to see whether another “free” retirement savings choice surfaces from the President’s recent announcement of the MyRA savings program (see my colleague Bob Collie’s post, Something for nothing).

The landscape of investment choices is changing quickly, but none of this changes the point I raised concerning potential benefits of diversification in a post late last year. Diversification is the primary reason most investors have purchased and will likely continue to hold bonds in their portfolios. Investment grade bonds have been and will likely continue to be the most reliable diversifier to equity risk — the major risk element in most investors’ portfolios. Put more simply, diversification from bonds essentially means that you may hold more return-seeking assets than you otherwise might.

Many investors often misjudge their own risk appetite in the good times, such as the US equity rally in 2013, only to find out that in the bad times they can’t withstand the pain so they reflexively move their portfolio into cash. Often this happens just before the market rebounds, and clients get whipsawed. Continuing to hold a diversifying allocation to bonds can help blunt the impact of the maximum pain point and allows clients to remain fully invested throughout the market cycle. Our experience suggests this diversified, fully invested approach may lead to the best client outcomes in the long run. My colleague, Graham Harman, added good perspective on the potential benefits of bonds in his recent blog post, “Cash is not trash in 2014. Neither are bonds.

While other asset classes, such as commodities, can compete with bonds for title of best diversifier to stocks based on the metric of correlation, few can match the generally reliable capital preservation and low volatility of investment grade bonds. Some may question the capital preservation effectiveness of bonds after the bond market decline in 2013, but we still believe we are unlikely to see a double-digit bond market decline on investment grade intermediate bonds that materially erodes a client’s capital base. Importantly, the low volatility characteristics of bonds in general are what make them such a reliable diversifier when compared to other diversifier options. Other choices may generate higher returns, but typically with higher volatility and, therefore, less reliability.

Keep in mind that a -2% year in bonds is probably considered a very bad year, but that did occur in a year in which the U.S. equity market was up over 33%.[2] Many investors will more readily accept some degree of negative bond performance if they understand the long-term advantages of an asset class dedicated to diversification with low volatility. Of course, investors may also use additional diversification strategies, such as duration management, active credit exposure, and a variety of long-short strategies —all aimed at fulfilling return outcomes while staying true to the low volatility and diversification roles of bonds in a total portfolio.

So, if we agree that bonds still deserve an important seat at the table, let’s turn to the more pressing question of how to hold them. I’ll cover this in my next post.


[1] Barclays U.S. Aggregate Bond Index, as of December 31, 2013

[2] Based on return of the Russell 3000® Index as of December 31, 2013

Disclosures:

Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Bond investors should carefully consider risks such as interest rate, credit, repurchase and reverse repurchase transaction risks. Greater risk, such as increased volatility, limited liquidity, prepayment, non-payment and increased default risk, is inherent in portfolios that invest in high yield (“junk”) bonds or mortgage backed securities, especially mortgage backed securities with exposure to sub-prime mortgages.

The Russell 3000® Index measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market. The Russell 3000® Index is a registered trademark and service of Russell Investments.

Barclays U.S. Aggregate Bond Index: An index, with income reinvested, generally representative of intermediate-term government bonds, investment grade coporate debt securities, and mortgage-backed securities. (specifically; Barclays Government/Corporate Bond Index, the Asset-Backed Securities Index, and the Mortgage-Backed Securities Index).

Russell Investments is the owner of the trademarks, service marks and copyrights related to its indexes.

Russell Investment Group is a Washington, USA corporation, which operates through subsidiaries worldwide, including Russell Investments, and is a subsidiary of The Northwestern Mutual Life Insurance Company.

Copyright © Russell Investments 2014. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty.

http://www.russell.com/

© Russell Investments

Read more commentaries by Russell Investments