For Portfolio Diversification, Bonds Never Go Out Of Fashion

MODERNIST’S ASSET CLASS INVESTING PORTFOLIOS ARE STRATEGICALLY INVESTED WITH A FOCUS ON LONG-TERM PERFORMANCE OBJECTIVES. PORTFOLIO ALLOCATIONS AND INVESTMENTS ARE NOT ADJUSTED IN RESPONSE TO MARKET NEWS OR ECONOMIC EVENTS; HOWEVER, OUR INVESTMENT COMMITTEE EVALUATES AND REPORTS ON MARKET AND ECONOMIC CONDITIONS TO PROVIDE OUR INVESTORS WITH PERSPECTIVE AND TO PUT PORTFOLIO PERFORMANCE IN PROPER CONTEXT.

ARTICLE CREDIT: jared kizer, cfa, Modernist’s Investment Committee

When it comes to portfolio diversification, the main purpose of fixed income, or bonds, is to protect the wealth you’ve accumulated. While stocks provide greater potential for growth, bonds help insulate portfolios from the larger price swings of the stock market.

In fact, there’s only been one year since 1970 when both global stocks and five-year U.S. Treasury notes produced negative returns, and that year was 2022. (1) So, why did last year prove to be such a challenging one for fixed income investors? The main reason was the significant increase in interest rates – the year-over-year increase in the five-year Treasury rate was the largest in the last 60 years. (2) When interest rates go up, bond prices go down.

Although years like 2022 have been rare, naturally they can lead investors to question the value of fixed income within a diversified portfolio. While there is no perfect way to diversify a portfolio, investing in high-credit-quality bonds with relatively short maturity dates is typically the most reliable way to protect the portfolio from the risk that more volatile investments, like stocks, will experience losses.

Are Bonds Set To Make a Comeback in 2023?

One silver lining of 2022 is that long-term expected returns for bonds have dramatically improved. As the chart shows, by the end of 2022 the yields on Treasury inflation-protected securities (TIPS) had increased from negative territory to positive. (3) This means long-term expected returns relative to inflation have also gone from negative territory to positive.

While there is no way to know what the future holds, fixed income should remain a strong diversifier against stock market risk, and the long-term outlook for expected returns has significantly improved. That should give investors some comfort that they can still count on bonds to help smooth portfolio returns.