Summary

• A soft start for the U.S. stock market in 2015 once again illustrates the diversification benefit of high-quality bonds even at very low yields.
• Even in a low-yield environment, bonds provide a cushion as price movements, not yields, are the primary buffer to equity movements.
• An allocation to core bonds, in addition to more attractively valued high-yield bonds, may make sense for investors.

By LPL Financial

The presence of record, or near record, low yields in early 2015 has diminished bonds ability to provide diversification benefits for investors. Bonds are off to a strong start so far in 2015, in part due to stocks stumbling out of the gates to start the new year. One year ago, at the start of 2014, strong equity market performance in 2013, combined with a tough year for bonds and still low yields, caused some investors to overlook the fact that bonds can still serve as an effective diversification tool. Fast forward to early 2015 and many overseas bond markets are offering all-time record low bond yields. In the United States, the 30-year Treasury yield closed January 2015 at a fresh record low with the 10-year Treasury not far from its 1.4% all-time low of 2012. This week we revisit our Why Own Bonds? commentary from January 14, 2014, to illustrate that bonds, even in a lower-yield environment, can still provide diversification benefits.

As corporate earnings move higher, the case for stock investing remains compelling, in our view. Still, pullbacks can occur without warning and, as mentioned in our Outlook 2015: In Transit. we expect more volatility, as is typically common when the economy enters the latter half of the business cycle. Pullbacks of 5% or more have been infrequent over recent years but such calm is rare. Investors with shorter-term horizons may consider seeking protection against an equity market sell-off. After all, the average annual peak-to-trough decline in the S&P 500 has been 16% (over the past 50 years) and pullbacks arrive without warning. Investors need to be prepared and bonds can help provide protection.

Over the last few months, pullbacks have indeed become more frequent. The broad stock market, as measured by the S&P 500 Index, declined by almost 7.5% in October 2014 and by nearly 5% in December 2014. These pullbacks were brief, but the current pullback from December 29, 2014, through January 30, 2015, has been longer and reached -4.1% before a bounce back on Monday, February 2, 2015. In contrast, the high-quality bond market, as measured by the Barclays PLC (NYSE:BCS ) (LON:BARC) Aggregate Bond Index, gained 2.1% during January 2015. Clearly, bonds offered a diversification and wealth preservation benefit during a tough month for stocks.

This is nothing new. A look back at prior stock market pullbacks illustrates how bonds have historically provided good diversification benefits. Figure 1 shows all equity market pullbacks of 5% or more that lasted at least three weeks over the past 11 years, with the corresponding returns for stocks and high-quality bonds. The figure also illustrates the hypothetical return of a balanced 60% stock/40% bond portfolio and the dampening impact bonds can have on stock weakness. During stock market pullbacks in excess of 5%, bonds outperformed stocks by a double-digit margin, a significant difference. Excluding the historic mid-2008 to early-2009 sell-off, the performance differential narrows but is still notable at a 9.6% advantage in favor of high-quality bonds.

In a few cases, both stocks and bonds declined together. This is a troubling outcome and reflects a failure of diversification, but it is rare. Still, bonds managed to outperform stocks on those occasions. In 2008, high-quality bonds provided a buffer but not without volatility, as investment-grade corporate bonds declined for the year and even high-quality mortgage-backed securities (MBS) suffered brief declines. While not all segments of the bond market perform similarly every time, an allocation to high-quality bonds can potentially be effective at offsetting stock market weakness. Although the current pullback in equities has not reached 5%, and may not, bonds are once again showing their diversification benefits.

A total of 13 central banks have lowered interest rates so far in 2015, and combined with quantitative easing (QE) from the European Central Bank (ECB), helps explain part of bond market strength early in this year. However, it does not detract from the potential diversification benefit still prevalent.

Not about yield

Todays very low-yield environment does not negate the potential diversification benefit of bonds. During 2012, the stock market suffered two pullbacks greater than 5%, and bonds rose more than 1% over each period. The 10-year Treasury yield varied between 1.4% and 1.9% during the 2012 equity market sell-offs, similar to todays levels.

In fact, during each stock market pullback in Figure 1, bond market performance was fairly consistent, averaging 1%, despite varied levels of interest rates. Two of the bond markets strongest gains during stock market sell-offs occurred in 2010 and 2011, a post-recession period in which yields had already declined sharply.

Over short-term periods, price movement, not interest income, is the primary driver of bond performance. Interest income accrues slowly, and although it is the primary driver of long-term bond returns, price changes (up or down) often overwhelm the impact of interest income over short periods of time. Therefore, a low-yield environment does not preclude bonds from acting as an effective diversification tool.

Conclusion

Low yields will likely translate into lower long-term bond returns, and therefore the hurdle for stock investors to beat bond performance over the long term is lower. However, for investors with shorter horizons or those simply unwilling to endure stock market swings, bonds can play a diversification role even in todays low-yield environment. In conjunction with sectors that historically hold up better against rising rates, such as high-yield bonds and bank loans, an allocation to core bonds may make sense to protect against potential stock market weakness.

Disclosure: None