At the beginning of March, we examined the recent bond market sell off and asked, “why you should I care?” For pure bond investors, the answer is straight forward – rising interest rates equals lower prices which can cause losses in principal that take years to recover.
But as we discussed, even if you’re a pure equity investor, sell-offs in bonds can affect you. When interest rates rise, bonds become more attractive investment options to many investors. As money flows into bonds, less cash is available to move into equities. For small rises in interest rates this effect will be negligible. But for larger rises in interest rates, the effect can be significant.
In addition, there’s a whole class of institutional investors (such as pension and insurance funds) that are required to maintain a certain percentage of their portfolios in bonds. As bond prices decline, these funds will find themselves holding insufficient bonds as a percentage of their total portfolio. To get back into balance, they have to sell other assets, usually equities, and use the proceeds to buy more bonds.
Despite this apparent correlation in the fates of bonds and equities, bonds are still a critical piece of a well-balanced portfolio. While cases like those described above occur, bond prices more often tend to move with a low correlation to stocks, and thus may provide positive returns in times when stocks struggle.
Take a look at the chart below. The purple line shows the results of having been invested in SPY, the exchange traded fund that’s designed to track the S&P 500. The orange line shows what would have happened if you had replaced one fifth of the portfolio with IEF, and exchange traded fund that tracks a basket of US Treasury bonds with 7-10 years left to maturity.
Yes, returns drop by adding bonds into the mix. But let’s dig a little deeper, because risk in the blended portfolio falls by more than decline in return.
As you can see, by adding bonds, annualized returns fall from 10.94% to 10.04% – an 8.25% drop in return. One common measure of risk is Maximum Drawdown – the amount of the single biggest decline in portfolio value. In the portfolio that also holds both equities and bonds, Max Drawdown fell by ~20% (from 55% all the way down to 44%); on a percentage basis, this is significantly greater than the drop in return that came about by adding the bonds.
We can do a little math and calculate a risk adjusted return measure by dividing the total return by the Max Drawdown. This risk adjusted measure actually rose by 6.4% simply by adding bonds! In plain English, it means you can sleep better at night (with less risk).
And here’s the fun part (as long as you’re not already fully invested). For the same amount of risk as buying and holding the S&P 500 ETF, you could have owned 25% more of the mixed portfolio, had the same historical drawdown as the S&P only, AND gotten an increase in annual returns from 10.94% to 12.5%!
And we’re not done yet, this is just the beginning of a number of ways we still have to construct a more balanced portfolio that would have narrowed the gap even more.
Jim, Mark, and Dave
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