Why We Don’t Abandon Bonds

Adopting the perspective of ‘risk budgeting’

Image courtesy Kurtis Garbutt

by Gregg S. Fisher

Bonds have performed nicely this year and stocks recently seem to be on another “bull run”. What’s not to like? Still, it seems that in almost any environment, there is something in a diversified portfolio that vexes investors. In recent days, I’ve heard variations on the same theme: Why should I continue to purchase Treasuries and municipal bonds at extremely low interest rates (the five-year Treasury yielded 1.68% on June 9)? Why not shift that money into stocks or high-yield bonds (aka junk bonds) with respectable yields?

A Hedging Tool

One way to consider this question is from the perspective of “risk budgeting”. In this view, an investor uses bonds to reduce portfolio volatility—a hedging role—by balancing riskier holdings such as stocks, REITs and commodities. By reducing fixed income risk, they can take risk in stocks and alternative classes with an understanding that investors are better compensated for accepting volatility in these asset classes than in bonds. Remember, from January 1, 1926 to May 31, 2014, the equity risk premium for US stocks (relative to 1-month Treasury bills) was 6.6% (Source: S&P Index Services).

We believe, due to our studies in behavioral finance and our experience with clients, that investors will not earn this premium if they panic and sell their stock holdings based on short-term, negative market events. This risk-averse behavior is another part of why managing a portfolio’s expected volatility is such a key component of asset management. Typically, I advise investors to look at high-quality, short- to medium-term bonds such as Treasuries (domestic and foreign), Agencies, and Municipal bonds, as these tend to reduce overall portfolio volatility and provide liquidity and rebalancing opportunities when stock prices plunge unexpectedly. In bull markets such as we’ve had recently, investors often tend to lose sight of these facts and forget how market volatility feels on the downside.

In addition to the logic of specifically targeting low-risk fixed income, is there anything wrong with moving money from low-yielding Treasuries or Agencies to higher-yielding junk bonds to boost the portfolio’s yield in a low- rate environment? The biggest issue with this approach is that high-yield bonds tend to behave much more like equities than other bonds. For instance, from June 1, 2004 to May 31, 2014, the Barclays US Corporate High Yield Index had a relatively high 0.73 correlation with the S&P 500 Index, while that of the BofA Merrill Lynch 1-3 Year US Treasury and Agency Index with stocks was negative 0.28 (Source: S&P Index Services).

Look Abroad, Too

Clearly, from a portfolio diversification standpoint, short-term, high-quality paper would appear to be a much better hedging tool than high-yield bonds. In fact, our research bears this out. We studied asset class performance during each of the 352 months from January 1985 to April 2014. During months in which equities rose (65% of the time), high-yield bonds were by far the best performer among the five bond categories we studied (see Exhibit ).

GF_Why_We_Don’t_Abandon_Bonds_Blog_Chart
But in months when the stock market declined, high yield also performed poorly and lost significant value. The best performers during those down months were US and foreign Treasuries. Along with short-term US Treasuries, investors should also give thought to investing a portion of their bond portfolio in international bonds to hedge currencies and to diversify exposures to economies and interest-rate cycles.

For more insight into our thinking on bonds, we invite you to read our research paper: Creating Investment Excellence: The Gerstein Fisher Approach to Managing Fixed Income.

Conclusion

Despite today’s low yields, investors should think carefully before abandoning high-quality bonds such as Treasuries and Municipals. Bonds such as these not only reduce overall portfolio volatility but also provide liquidity and peace of mind for investors when stocks turn turbulent. Investors may also consider adding an allocation to short-term, high- quality foreign bonds for diversification and return.

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