It’s been another very good year for stocks and another lacklustre one for bonds. That’s led many investors to wonder whether they should be allocating more money to stocks and less to bonds.
To the end of September, Canadian stocks were up 17.5% this year while bonds were down 4% (including interest and dividend income). Despite this performance, our advice is to proceed cautiously when considering increasing the equity weighting in your portfolio at the expense of bonds.
Yes, stocks have had strong returns since the markets bottomed out from the COVID crash in March 2020 while rock bottom interest rates have meant paltry bond yields of little more than 1%.
However, bonds do more work than just contribute to your overall returns. They play a critical role in diversifying your portfolio by acting as a shock absorber when corrections hit the stock market.
This is because bonds—especially the short-term, high-quality ones we favour—are much less volatile than stocks.
That’s important to remember at a time when equity markets have been so strong for so long. Even before the rapid recovery from the pandemic shock, stocks had a great run dating back to the rebound from the 2008-09 financial crisis. The good times have desensitized many investors to risk as we see in the surge of speculative trading in hot stocks, cryptocurrencies and special purpose acquisition companies. But risk hasn’t gone away.
We can see the shock-absorbing effect of bonds through a metric known as the Sharpe ratio. Named for its inventor, Nobel laureate William Sharpe, it measures the performance of an investment compared to a risk-free asset, after adjusting for risk. When comparing two portfolios, the one with a higher Sharpe ratio provides a better return for the same amount of risk.
As economist and market strategist David Rosenberg demonstrates in this article the addition of a meaningful portion of bonds to a portfolio dramatically improves risk-adjusted returns.
Rosenberg calculates that an all-stock portfolio over the last five years had a Sharpe ratio of 1.08 compared to 1.2 for a portfolio composed of 60% equities and 40% bonds and 1.25 for a 50/50 mix. So, despite the low returns of bonds over the last five years, the Sharpe ratio increases because the bonds substantially reduce the volatility of the portfolio. The same pattern can be seen over 10-, 20- and 30-year periods.
Besides being a buffer against volatility in the stock market, there’s another reason why bonds are useful in a portfolio. When the stock market suffers losses, you can use your bond allocation to raise cash to cover your spending needs, while you wait for equities to recover. You can also use it to buy stocks when they are down.
Of course, a 100% stock portfolio will have higher expected returns, but it is also riskier. Good portfolio management involves finding the right balance between risk and reward given your goals and tolerance for risk.
The bottom line is we believe a bond allocation should viewed as a portfolio stabilizer, not an impediment to maximizing your returns. Experience has taught us that a lower volatility portfolio is going to produce better, more tax efficient performance over the long run than a highly volatile one.
So, don’t worry about your bonds, they’re doing their job.