It’s good news that bonds fell last year.
I doubt this will of course be your reaction when reviewing the 2021 performance panels. The total US domestic bond market lost 1.9% last year, according to a Vanguard Total Bond Market ETF BND report,
Long-Term Treasurys lost even more, losing 5.0% (estimated by Vanguard Long-Term Treasury ETF VGLT,
). You might think it’s hard to put lipstick on this pig.
The reason I think we should try: Bonds are a diversification factor for your retirement portfolio – reducing the volatility-based risk otherwise associated with your entire stock portfolio. But being a factor of diversification means that you should meander when stocks meander, and vice versa. And that’s exactly what they did last year.
Those disappointed with the bond’s performance last year want to have their cake and eat it. But this is magical thinking: you can’t expect connections Both To be a diversification factor in your portfolio And They should go up when the stock goes up. Given the impressive performance of the stock market last year – up 25.7%, as estimated by the Vanguard Total Stock Market ETF VTI,
– So it shouldn’t come as a huge surprise that Bonds suffered.
Another way in which last year’s bond struggle is good news: It runs counter to the narrative early in the pandemic that there has been a more or less permanent increase in the correlation of bonds and equities. According to that account, interest rates had become so low that they had nowhere to go but higher. If so, investors will delude themselves into hoping that bonds will cushion any downturn in the stock market.
In light of what happened last year, it now appears that the positive correlation between stocks and bonds in early 2020 was a temporary phenomenon. This is illustrated in the accompanying chart, which plots the six-month lag correlation between total stock markets and total bond markets. Note that although this correlation reached very high levels in early 2020, it has since fallen back to previous levels.
Hope in the portfolio 60:40
The return of the negative correlation between stocks and bonds suggests that it would be too soon to throw the towel at 60% of stocks/40% of a bond portfolio – perhaps the most common asset allocation used by retirees.
You may still have some reservations, since interest rates – although not as low as they were in the early stages of the pandemic – remain very low by historical standards. But research by the Portfolio Solutions Group, part of AQR Capital Management, has found that low rates are not – in and of themselves – a reason to give up hope and belief that bonds can be a good diversification factor.
The study, which I first wrote about last May, urges us to focus instead on the extent to which interest rates can fall in any 12-month period. Only if you think rates can’t go down much – 50 basis points or less – should you question the bond’s ability to be a good diversification tool. As long as you think rates can fall by at least 100 basis points, the bonds maintain near their full potential for diversification.
This prerequisite is currently met. In the past 18 months, rates have been much less than 100 basis points than they are today. In fact, the 10-year Treasury yield is currently 1.76%, 125 basis points higher than in the summer of 2020.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert rating tracks investment newsletters that pay a flat fee to review. He can be reached at [email protected].