The value of bonds in an equity market downturn
When equity markets are buoyant and stock market indices are seemingly reaching new market highs on a daily basis, it’s easy to question why people should advocate investing in bonds. After all, in the current interest rate environment, it’s difficult to find returns materially above four percent, and in a lot of cases, lower still.
However, the last month is hopefully a timely reminder as to why we look at investing from an overall portfolio perspective, which includes multiple asset classes (equities, bonds, property and cash). The NZX50 returned -6.15% for the month of October 2018, which is the eighth worst month for the index in the last twenty years, although five of those were during the Global Financial Crisis (GFC)). This might seem like a trite statistic but it illustrates the level of volatility we’ve seen recently. Conversely, the New Zealand S&P Corporate ‘A’ Bond Index returned 0.40% amidst the turmoil.
Diversification is a term that, in my opinion, is used too loosely in our industry. It’s often meant to imply that if you’re well diversified, then your investments are protected. This may often be true, but the question we need to really ask is how correlated are the returns across the different investments someone is holding. In other words, if equity markets are going down, how are your other investments performing? This brings me back to the bond allocation argument.
Bonds tend to be only appreciated by investors when sentiment turns sour in equity markets. My point here is that no one will thank you for holding bonds when times are good, due to the lower rate of return and ‘drag’ on your portfolio performance.
However, one of the key reasons they are there is to give investor comfort that all things being equal, their capital (initial investment) is solid, and their income (coupon, interest payment) is known. One of the key learnings from the GFC was that in a true ‘risk off’ environment, most asset classes are correlated with the exception of bonds. This means that regardless of how diversified you were across geographies, most of your investments were tracking lower in price, with the exception of bonds.
Long run statistical data confirms that equity markets will outperform bonds over the longer term. Spreading your risk between more than one asset or asset classes gives you the potential for varying returns as each asset contains a different level of risk.
Andrew Carnegie, the Scottish-American industrialist and one of the wealthiest people of his generation, didn’t favour dispersing capital, suggesting that those who did had “scattered their brains as well” For most of us, however, diversifying investments is a way to reduce the risk of a tumble in markets, and losing what we have worked hard to save.