Bonds play an important role in a portfolio for many investors. A basket of high-quality bonds will provide a steady return stream, and when added to a portfolio of stocks, they provide some stability if stock markets are declining.
Though most bonds will carry very low risk and have limited volatility compared to stocks, there are still two main risks associated with bond investing.
- Credit risk, which is related to the bond-issuing company’s ability to pay
- Interest rate risk, which is more relevant to this piece and involves the way a bond’s price changes as interest rates in the bond market change
Generally, when one purchases a bond, there is an agreed upon interest rate that is locked in until the bond matures. Throughout the life of the bond there is likely to be changes in the interest rates offered for new, similar bonds. If the interest rate offered on new, similar bonds is higher than the bond you already own, then the market value of the bond you own would go down. The price that other investors are willing to pay for your bond has decreased because they are able to get higher interest rates elsewhere. Bonds that have longer maturities will carry higher interest rate risk, as there is a higher chance of the interest rate environment changing during the life of the bond.
The chart below shows the average annual return and standard deviation (a measure of risk) for two bond indexes since 1976. One index is made up by bonds with one to five years left until maturity (short-term bonds), and one index is made up by bonds with five to 10 years left (intermediate-term bonds).
Source: Bloomberg Barclays 1-5 Year US Government/Credit Total Return Index and Bloomberg Barclays 5-10 Year US Government/Credit Total Return Index
Investors who were willing to take on the additional interest rate risk earned an additional 1.23% per year, though the 3.02% increase in standard deviation was much greater.
A Look at the History
Very few investors would invest solely in short-term bonds or intermediate bonds though. What if we looked at the history of these bond indexes when combined with an index of stocks? Below shows the historical standard deviation and return over the same time period for a portfolio of 60% S&P 500 and 40% in one of the bond indexes.
Source: 60% S&P 500 Total Return index / 40% Bloomberg Barclays 1-5 Year US Government/Credit Total Return Index and 60% S&P 500 Total Return index / 40% Bloomberg Barclays 5-10 Year US Government/Credit Total Return Index
As you can see, the difference in the standard deviation is not nearly as significant. The portfolio with 40% in 5-10 year bonds had a higher annual return by 0.52%, though the difference in standard deviation was only 0.50%. This is considered a great result in the world of finance, as a higher ratio of return to risk, or risk-adjusted return, is better.
The short-term bonds achieve a higher level of return relative to the amount of risk on their own, though adding intermediate-term bonds to a portfolio of equities actually achieves a higher risk-adjusted return than what you’d achieve by adding short-term bonds. This is because intermediate-term bonds act as a better diversifier than the short-term bonds. This is especially true during poor periods for equity markets when interest rates are more likely to decline. The higher amount of interest rate risk from the intermediate-term bonds is actually a good thing in this case, as it naturally serves as a hedge for the most significant risk in your portfolio – equity risk.
Bonds and the Power of a Diversified Portfolio
This is a great lesson in the power of diversification and what happens when you own a basket of investments that behave differently during different time periods. While initially intermediate-term bonds look like they may not be worth the additional risk on their own, they are a useful piece of a diversified portfolio.
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