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Recent positive correlation observed between the two asset classes has perplexed investors about the utility of bonds in a portfolio. In his previous article, Bilal Hassanji, Senior Investment Strategist at Vanguard, looked at the importance of focusing on income, not just price, when considering bonds in a rising rate environment, and on lower duration, which decreases price sensitivity to interest rates. In this article he offers three more reasons why rising interest rates will help drive higher returns for bond investors; and why he believes the positive correlation between stocks and bonds in 2022 is a unique one-off event and not indicative of a broader trend.
Bond yields have improved drastically across Canada, U.S.. and global aggregate bonds over the past year and have reached levels not observed since 2007, as shown in figure 4. And rising yields have contributed to a marked improvement in bond return expectations over the past year.
With rising nominal yield levels observed across developed markets because of higher inflation and higher interest rate expectations, we see a significant improvement in bond returns since the year-end 2021, over the next 10 years, as described in Figure 5.
At the end of December 2022, we anticipated that the median 10-year return for Canadian bonds will range from 3.4% to 4.4%, around a 2% per annum increase from our forecast at year-end in 2021. Likewise, for global aggregate bonds (ex-Canada, hedged), we now anticipate median 10-year returns of 3.2% to 4.2%, over 2% per annum improvement since the last year.
Bonds usually act as a ballast in multi-asset portfolios by providing a hedge against market drawdowns.
The chart on the left in Figure 6 illustrates that even during the worst decile of U.S. equity returns, emerging-market equities (–8.7%) and global ex-U.S. equities (–7.8%) performed worse than their U.S. counterparts (–7.2%). This shows that globally diversifying an equity portfolio may not be enough to offer protection against U.S. equity underperformance because of the correlation across global equity markets.
If an investor is seeking greater downside protection against U.S. equity market risk, then a well-diversified portfolio containing stocks and bonds seems to be the answer. In fact, during periods of equity market stress, high-quality fixed income acted as ballast, cushioning the losses in the equity portion of the portfolio. Moreover, the chart on the right shows that even during low yield environment, high quality bonds have offered more downside protection in a stock/bond multi-asset portfolio.
Stock and bond returns have frequently moved in the same direction and have even been positively correlated at times. But as with any investment performance, looking solely at short periods will tell you only so much.
As shown in figure 7, during much of the 1990s, stock-bond correlations were largely positive and have spiked into positive territory on numerous occasions since then. Correlations over the longer term, however, have remained negative since around the year 2000, and we expect this pattern to continue.
Moreover, our research, based on data from 1976 to 2022, shows that the time periods when both stocks and bonds have experienced negative performance get shorter as the observation period extends. Figure 7 shows stocks and bonds have both experienced negative performance in the same month 15.3% of the time, over the same three-month period 9.3% of the time, and over the same six-month period 4.8% of the time. But these two asset classes have both experienced negative total returns over one-year periods only 1.8% of the time. And since 1976, investors have never experienced a three- or five-year period during which both stocks and bonds sustained losses.
While the current investing environment is challenging for investors, Vanguard’s long-term outlook on bonds is positive. We believe that investors should focus on long-term total returns on bonds rather than the prices and let higher interest rates work in their favor by allowing the compounding to take effect.
Given the historically high yields, cash is no longer a good strategy because investors will lose the opportunity to compound at high rates. Lastly, bonds’ role as a ballast is proven, and given current market volatility, uncertainty on monetary policy, an inverted yield curve predicting an impending recession and thus future lower interest rates, having a sizable allocation to bonds based on your risk-return profile, can serve as a good strategy for discerning investors.
Bilal Hasanjee, CFA, MBA, MSc Finance, is Senior Investment Strategist at Vanguard Investments Canada.
Disclaimer
© 2023 by Vanguard Group. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. This article first appeared March 24, 2023, on the “Insights“ page of the Vanguard Group, Inc.’s website. Used with permission.
The views expressed in this material are based on the author's assessment as of the first publication date (July 2021), are subject to change without notice and may not represent the views and/or opinions of Vanguard Investments Canada Inc. The author may not necessarily update or supplement their views and opinions whether as a result of new information, changing circumstances, future events or otherwise.
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