With bonds posting some of their worst declines on record this year1, many investors have been questioning if they still merit the same allocation in their portfolios.

High-quality bonds are meant to act as a buffer against equity market volatility due to their historically negative correlation with shares2. Yet bonds have spent much of 2022 in simultaneous freefall alongside equities—leading some observers to speculate if this more positive relationship between asset-class returns signals a more permanent trend.

For investors, such speculations make tactical shifts to asset allocation seem more compelling—but we believe that now is not the time to move away from bonds. As we’ll discuss in more detail below, short-term reactive shifts to market conditions often leave a portfolio inappropriately allocated for the market environment that follows.

Importantly, bonds look more attractive now than they have done for quite some time, with yields broadly above longer-term inflation expectations and higher interest payments providing tangible levels of income. Critically, for multi-asset investors, there are signs that bonds are beginning to act once again as a stable hedge against equity risk.

The role of bonds when rates are rising

Steep rises in interest rates have been driving the recent declines across bond markets. But it’s not all doom and gloom for bond investors: higher rates should ultimately benefit investors, so long as they stay invested long enough to realise the potential gains.  As older bonds mature and get replaced with new, higher-paying bonds, the higher income streams from the new bonds will eventually replenish any short-term losses and provide investors with higher total returns than they would have otherwise earned before the rate increases.

To understand why, it’s helpful to consider the relative importance of interest income compared with movements in bond prices when calculating the total return of bonds (Figure 1). The compounding effect of reinvested interest income means the total return from bonds depends far more on the interest income they earn than any changes in their face values. In fact, income has accounted for more than 90% of the average annual return of the US bond market over the past two decades3.

Figure 1: Interest income drives bond total returns 

Notes: Monthly data are from 1 October 2000 to 31 March 2022. EUR aggregate bonds are represented by the Bloomberg Germany Aggregate Bonds Total Return Index in EUR. All bond income is assumed to be reinvested. The performance data shown represent past performance. Past performance is no guarantee of future results. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Source: Bloomberg.

Keep in mind that rising rates will have different consequences depending on the client’s investment horizon. As a rule of thumb, an investor can benefit from a rate increase through higher total returns, so long as their investment timeline is longer than the duration of their bond portfolio4.

The counterbalancing force of bonds

We believe the recent positive correlation between equity and bond market performance, while understandably uncomfortable for investors, is unlikely to be sustained.

Since the early 2000s, the correlation between equities and bonds has been broadly negative (Figure 2). This relationship has persisted through high and low interest rate environments and bull and bear market cycles. Importantly, it has endured during times of significant financial shock—including the Great Financial Crisis (GFC) of 2008 and the start of the global pandemic in early 2020. Back in 2008, when global equities plummeted roughly 34%, high-quality bonds returned more than 8%; similarly, in early 2020, when the global pandemic sent equity markets plunging 16%, global bonds returned 1%5.

Figure 2: The correlation between equities and bonds has been broadly negative for the last two decades

Notes: Correlation data represent the relationship between German equities and German government bonds. Correlations calculated on a three-year rolling basis using monthly data for the DAX Index and the Bloomberg Barclays Germany Government All Bonds Total Return Index from January 2003 to 31 March 2022. All figures are in EUR.
Source: Bloomberg.

Thinking about the current market, we expect ongoing inflationary concerns will mean asset-class correlations remain elevated, but only modestly. Looking ahead, we believe the impact of future rate rises has now largely been priced in, and bonds will resume their role as an effective hedge against equity risk. Fears of weaker economic conditions are likely to only strengthen the risk-diversifying role of bonds.

Bond diversification provides built-in protection 

A highly diversified bond portfolio can help investors mitigate the short-term impact of fluctuating bond prices and rising rates. That’s why Vanguard’s multi-asset solutions maintain a diversified allocation to high-quality fixed income, including investment-grade domestic and international corporate bonds and government debt with varying maturities. This includes short- to intermediate-duration bonds that are less affected by rate increases. Additionally, we hedge against global currency fluctuations to help reduce volatility and provide smoother returns.

Conclusion

Predicting when and how rising rates will impact portfolio performance is notoriously difficult. At times like these, it’s worth reminding ourselves that a strategic approach to asset allocation doesn’t rely upon tactical responses to market conditions to achieve intended outcomes for investors. More often than not, tactical moves can leave a portfolio inappropriately allocated for the market conditions that follow.

Rather than trying to mitigate the impact of short-term market movements, our multi-asset strategies employ time-tested principles that have helped our investors achieve their goals through a range of market environments.

 

1 Source: Bloomberg. Returns for Bloomberg Global Aggregate Index USD Hedged, as at 30 June 2022. The first-half 2022 performance is the worst since the inception of the index on 1 January 1990.

2 Renzi-Ricci. G and Lucas Baynes, "Hedging equity downside risk with bonds in the low-yield environment", Vanguard Research, January 2021.

3 Source: Bloomberg. Calculations in USD and based on the Bloomberg US Aggregate Index in USD. All bond income is assumed to be reinvested.

4 For more information on how rising rates and falling bond prices can affect bond investors with different time horizons, see “The dynamics of bond duration and rising rates”. 

5 Source: Bloomberg. Global equities refer to the MSCI ACWI Total Return Index; high-quality bonds and global bonds refer to the combined values of the Bloomberg Global Aggregate (ex-USD) Index and the Bloomberg US Aggregate Bonds Index. Calculations in USD.

Investment risk Information

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Past performance is not a reliable indicator of future results.

Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.

Important information

For professional investors only (as defined under the MiFID II Directive) investing for their own account (including management companies (fund of funds) and professional clients investing on behalf of their discretionary clients). In Switzerland for professional investors only. Not to be distributed to the public.

The information contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.  The information in this document does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this document when making any investment decisions.

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