Why It’s Time to Rethink Bonds as Markets Near New Highs

Commentary

Bonds are often taken for granted by investors. In fairness, bonds tend to underperform stocks over the long term. Currently, stock markets are near all-time highs and returns have been strong in recent years, so this perspective is understandable. However, given today’s high valuations and growing global uncertainty, now is a good time to reassess fixed income, especially bonds.

Bonds provide steady income for investors. Government-issued bonds from reasonably creditworthy nations have delivered their promised coupons for generations. A well-balanced bond portfolio can typically be relied on to generate positive returns over medium- to long-term periods. The same cannot be said for stocks, which have experienced extended periods of negative returns, including the years following the 1929 crash and the stagnation from the mid-1960s until the secular bull market that began in the early 1980s. Furthermore, the U.S. market has outperformed most global markets. Countries such as Japan and some in Europe have experienced prolonged periods of poor equity returns.

Bonds reduce the expected volatility of a balanced portfolio. There are two key reasons for this. First, when stocks crash, bonds typically don’t fall by the same amount. Second, bond price volatility depends on the term to maturity. Shorter-term bonds have lower price volatility, while longer-term bonds have more. Investors are generally compensated for this added risk, as longer-term bonds usually offer higher yields than shorter ones. Although yield curve inversions—when short-term yields exceed long-term yields—do occur, they are never permanent. Historically, long yields have exceeded short yields the majority of the time. Over the past four decades, yield curves have been normal (non-inverted) about 90 percent of the time, a figure slightly biased downward because of recent anomalies.

Longer-term bonds also reduce risk because they often rally during stock market sell-offs, as investors shift from equities to government bonds in a “flight to safety.” Market crashes tend to coincide with economic downturns, and during such times, investors expect central banks to cut interest rates, raising bond prices. Although this did not occur during the COVID-19 pandemic crisis, that period was a historical anomaly. It featured unprecedented monetary stimulus and interest rate lows never before recorded in the history of major economies.

Bonds carry different types of risk: price risk, inflation risk, credit risk, liquidity risk, and reinvestment risk. There are also many types of bonds, classified in various ways, and issued by both governments and corporations. They differ by term, structure, and risk profile.

The bond market is primarily institutional. Relative yield differences between bonds tend to reflect the market’s pricing of risk, based on the “wisdom of the crowd.” Occasionally, apparent opportunities—or “free lunches”—arise, but these are typically not significant enough to justify the time and resources individual investors would need to compete with professionals who work full time and leverage powerful analytical tools.

In the bond market, more risk generally means higher yield. The only true “free lunch” is diversification. Many individual investors understand this, which helps explain the growth in bond exchange-traded funds (ETFs). Bond ETFs are diversified and typically have lower fees than mutual funds, which are often actively managed. Over time, after fees, most bond mutual funds underperform bond ETFs, leading to substantial portfolio differences for investors.

As the population ages, retirees and older investors will increasingly seek income and stability. Bonds play a crucial role in providing reliable cash flows to cover living expenses. Eventually, the stock market will experience a severe bear market. How do we know this? Because bear markets have always occurred, and always will, as long as markets exist. Major equity downturns are like Category 4 hurricanes striking the U.S. mainland: They may not happen for years, but they are inevitable.

The views and opinions expressed are those of the author. They are meant for general informational purposes only and should not be construed or interpreted as a recommendation or solicitation. The Epoch Times does not provide investment, tax, legal, financial planning, estate planning, or any other personal finance advice. The Epoch Times holds no liability for the accuracy or timeliness of the information provided.

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.