CapitalTime

Articles on investing and capital management, with a quantitative focus.

Why Invest in Bonds?

2023-10-20

Summary: People invest in bonds because they’re expected to outperform cash over the long term. Despite recent volatility, Aggregate Bond and Total Bond Market funds have a history of milder drawdowns than stocks. In nominal price terms, bonds are safer than stocks. However, bonds have significant inflation risk and a rather high probability of producing negative real returns (losing to inflation).

Bonds have performed very poorly in the last 3 years, with negative returns in 2021, 2022, and 2023 so far. The recent terrible performance and high volatility has made some people question the reasons for investing in bonds. Do bonds actually offer safety?

Long term investors (those who have 20 to 40 year time horizons) may also wonder if there is any point investing in bonds. With a very long time horizon, why not just invest in 100% stocks?

These are good questions, and I wanted to share my views. Please note that when I talk about investing in bonds, I mean holding some bonds inside a diversified portfolio. This could be something like a 60/40 (balanced) fund along the lines of XBAL, or perhaps a risk parity portfolio like mine.

Some basics

Both stocks and bonds are expected to outperform cash; this is why people invest in them. If you have a portfolio consisting purely of stocks, or bonds, you would see the portfolio value (total return) trending upward over time. The assets will sometimes drop in price, but should eventually recover and continue their upward trajectory.

An investor who holds both stocks and bonds would expect to see a combination of both returns. In the long term, both assets should (hopefully) produce positive returns — and outperform cash.

There will be periods of volatility and declines in each asset. The correlation between the two assets will change over time, and is not predictable. At times, there may be a positive or negative correlation between stocks and bonds. Recently, both assets have been moving in the same direction (positively correlated).

I think it can be helpful to step back and think about the big picture: these are two different asset classes which behave differently due to fundamental differences. Sometimes, they behave similarly, but ultimately they are each taking 'their own journey'.

Are bonds a "safe" investment?

All investments have risks. Here, I will talk specifically about bond funds and ETFs which hold broadly diversified bond portfolios of a high credit quality (referred to as 'investment grade'). These are usually called Aggregate Bond and Total Bond Market funds, and include these popular ETFs:

• XBB and ZAG in Canada
• AGG and BND in the United States

Please note that many different types of bond funds exist, and my comments apply to the above group.

These bond portfolios certainly have risk, notably credit risk (bond issuers could default/go bankrupt) and interest rate risk (sensitivity to rising interest rates). The investment grade bond funds tend to control their credit risk well, but could still suffer losses in extreme scenarios such as a major financial crisis.

Losses in bond funds over the last 3 years were entirely due to interest rate risk. Rates went much higher, and bond prices fell in response. This was a known risk.

Bonds also have inflation risk, which is the danger that returns might not keep up with inflation. Unfortunately, this has been the case in the last few years as well.

So why do people often talk about bonds as "safe" investments? Positive returns are not guaranteed, but bond funds usually have milder movements than stocks. Their prices tend to be more stable, and tend to not fall very much.

When bond funds (of the type listed above) fall, they typically decline about 5%. In contrast, stocks typically decline about 20% in a correction. Based on this usual behaviour, it's fair to say that bonds are generally less volatile than stocks.

But there can be unusual or 'outlier' events as well, and this is what we experienced recently. In 1980, bond funds declined by approximately 13% in a rising interest rate environment. Recently, bond funds declined 19% — a new historical maximum drawdown (since 1972).

These enormous declines surprised many people, including me! It seems that 2022 was the worst year ever recorded for bonds.

Here's a comparison of US stock and bond declines (drawdowns), including the worst cases in the last 50 years.

Note that bonds are significantly less volatile than stocks, both for the typical and worst cases. In terms of price movements and portfolio declines, I think it's fair to say that bonds are safer than stocks. Their prices are usually more stable than stocks.

However, bonds still have inflation risk — see the end of this post.

Why should a long-term investor hold bonds?

I understand why investors with very long time horizons may want to focus entirely on stocks instead of a combined stock/bond portfolio. Historically, stocks have performed better than bonds.

However, there are still some reasons to consider holding bonds in a long-term portfolio. When I refer to "bonds" in these comments, I am again referring to the group of diversified investment grade bond ETFs listed earlier.

Bonds reduce portfolio volatility

As I explained above, bonds are typically less volatile than stocks. When added to a portfolio, bonds help make the portfolio more stable, and lessen the severity of crashes. Stocks and bonds don't need to have an inverse correlation for this effect to work, though it obviously works best when they do. It's also worth noting that this volatility reduction is not guaranteed. Portfolio modelling (back-tests and Monte Carlo simulations) suggest that bonds improve a portfolio's stability, but financial markets can always surprise us.

People don't really know their time horizons

If a person is forced to sell and withdraw funds during a volatile period, they will experience a loss. Some investors say that volatility does not matter, because they have very long time horizons and simply won't sell during a bad period.

Unfortunately, life is very unpredictable and few people can predict what might happen 10 years from now, let alone 30 years. If life circumstances shorten the time horizon, then volatility might suddenly matter.

Stock market volatility is stressful

Crashes or corrections can be very stressful for some people. There can be strong emotional reactions, both to actual declines and even fears of 'imminent' declines. I have written before about how stocks are always scary, and there can be very good stories that come with those scary periods. Some people will not feel any of this stress, but I have met many people who did not enjoy stock crashes.

It’s difficult to imagine what a true bear market feels like until you have the pleasure of experiencing it yourself. Lines on a screen really don’t capture the effect, so I would caution people against assuming that they can handle a real crash / bear market unless they’ve actually experienced one. The last significant bear market was 15 years ago.

Diversification of asset classes

Going 100% stocks means an investor is concentrated in a single asset class. One can diversify between sectors or countries, but it's still a single asset class. Each asset class has its own unique risks and reward potential. I think the choice to go 100% stocks has more risk than just the volatility issue. It means going 'all-in' on a single kind of asset.

Bonds have big problems, too

Historically, bonds have underperformed stocks. There is significant inflation risk, meaning the risk that the bonds may fail to even outperform inflation. Professor Scott Cederburg has studied the long-horizon performance of asset classes, and notes that bonds have a rather high probability of producing negative real returns (losing to inflation).

This is a serious risk that should not be taken lightly.

When designing an investment portfolio, an investor has to weigh these different risks. Bonds help reduce a portfolio's volatility, but may significantly harm the long-term returns.

— Jem Berkes