High-Quality Bonds Still Best Antidote to Stock Price Drops

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antidoteThere is a constant search for the elusive “new” asset class that offers high returns but with low correlation to stocks. In Skating Where the Puck Was: The Correlation Game in a Flat World, William Bernstein points out that soon after one is “discovered”, the future returns and correlations will quickly change as to be useless. Past examples have included commodities futures and international REITs.

But this Vanguard Blog post reminds us that of the original stock diversifier: bonds. Here a chart of monthly asset returns during times of severe stock market drops:

vg_bonds_danger

See a trend? Investment-grade government-backed, corporate, and municipal bonds. While their long-term returns aren’t going to be as high as stocks, high-quality bonds remain the best asset class for diversifying against stock market price drops. You can compare these results to Bernstein’s guide to picking bonds.

Sure, interest rates will rise eventually. But we don’t know how much they will go up (could be very little), how fast (could be very slowly), or if they will stay higher (could drop down again). As long as you have high-quality and short/intermediate maturity lengths, bonds will keep on doing their job as the ballast in your portfolio. Check out the wiggly lines in this StockCharts.com interactive chart comparing the historical performance of ETFs tracking US stocks (VTI), international stocks (VXUS), and high-quality bonds (BND). Adjust the bottom time bar to adjust the lookback period.

vg_bonds_stockcharts

People will vary in how much bonds to have in their portfolios, but I like the idea of always having at least a little “slow and steady” stuff in my portfolio.

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Comments

  1. The most important statement in this article is “their long-term returns aren’t going to be as high as stocks”. Then why invest in bonds, it doesn’t make any sense. We have been discussing the ultimate retirement goal here for many years. That is to live only on dividends from your assets (i.e. you will never have to sell a single share of your VTI and VXUS). Of course during good times for the stock market you may still choose to sell some of it and treat yourself to a cruise around the world or buying a Ferrari. Isn’t that a smarter strategy?

    • simplesimon says:

      Because we’re talking about correlation and how to reduce volatility, not total return. A retiree needs to consider sequence-of-return risks as well as their own ability to sleep at night when the market is sliding downwards.

  2. Can we simplify what constitutes high quality bonds by ticker symbol? Does VBTLX (Vanguard Total Bond Market Index Fund) qualify under high quality bond fund? It had only 2.92 percent return along with the dividends over the last 5 years !

  3. There are so many good quality corporate bonds available in the secondary market at or below par, it seems to make no sense to buy a Vanguard or any other fund to get something below 3% when you can easily get 4.25% or greater. Vanguards BLV and VCLT are exceptions but interest rate risk effects the timing of the purchase of these funds whereas, if you hold a bond to maturity your principle is not subject to being reduced in value.

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