The good news hidden in the bond market losses in 2021

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It is good news that bonds fell last year.

I doubt that’s how you reacted when reviewing the 2021 performance dashboards, of course. The total US domestic bond market lost 1.9% last year, according to the Vanguard Total Bond Market ETF BND,
-0.27%.
Long-term Treasuries lost even more, losing 5.0% (judging by the Vanguard Long-Term Treasury ETF VGLT,
-0.69%
). You might think it’s hard to put lipstick on this pig.

The reason I think we should give it a try: Bonds are a diversification tool for your retirement portfolio, reducing the volatility-based risk that would otherwise be associated with a portfolio made up entirely of stocks. But being a diversifier means they should zag when actions zig, and vice versa. And that’s exactly what they did last year.

Those who were nevertheless disappointed with the performance of bonds last year want to have their cake and eat it. But it’s a magical thought: you can’t expect bonds both be a diversifier in your portfolio and that they should increase when stocks increase. Given that the stock market performed so spectacularly last year, up 25.7%, judging by the Vanguard Total Stock Market ETF VTI,
-0.46%
– it should therefore come as no surprise that bonds have experienced difficulties.

There’s another way the bond struggle last year is good news: It contradicts a narrative that emerged early in the pandemic that there had been a more or less permanent increase in the correlation between stocks and stocks. obligations. According to this story, interest rates had gotten so low that they had no choice but to increase. If so, investors would be deluding themselves into hoping that bonds would cushion any decline in the stock market.

In light of what happened last year, it now appears that the positive correlation between stocks and bonds in early 2020 was a temporary phenomenon. This is illustrated in the accompanying chart, which plots the correlation over the past six months between the total stock markets and the total bond markets. Note that although this correlation reached very high levels in early 2020, it has since reverted to earlier levels.

Hope for the portfolio 60:40

The return of the negative correlation between stocks and bonds suggests that it would be premature to throw in the towel on the portfolio at 60% equities and 40% bonds, perhaps the most important asset allocation. popular used by retirees.

You may still have some caveats, given that interest rates, while not as low as they were at the start of the pandemic, remain very low by historical standards. But research by the Portfolio Solutions Group, part of AQR Capital Management, reveals that low rates are not in themselves a reason to give up hope and belief that bonds can be a good means of diversification.

The study, which I first mentioned last May, urges us to focus instead on the extent to which interest rates might fall in any given 12-month period. Only if you think rates can’t go much lower – 50 basis points or less – should you question the potential of bonds to be a good diversifier. As long as you think it’s possible for rates to drop by at least 100 basis points, then bonds are holding near their full potential for diversification.

This precondition is currently fulfilled. Over the past 18 months, rates have been more than 100 basis points lower than they are today. Indeed, the 10-year Treasury yield currently stands at 1.76%, 125 basis points higher than it was in the summer of 2020.

Mark Hulbert is a regular contributor to MarketWatch. Its Hulbert Ratings tracks investment newsletters that pay a fixed fee to be audited. He can be contacted at [email protected].


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