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Earlier this year when schools closed in response to the COVID-19 outbreak, many parents and grandparents added the title of "teacher" to their roles, as students around the country took lessons online in virtual classrooms from their homes. During that time of unprecedented disruption to daily life, economic upheaval and stock market volatility, bond markets also taught time-tested lessons to investors on the importance of striking the right balance between an appropriate mix of stocks and bonds in long-term portfolios. Here are three lessons from the 2020 bond market that can help investors achieve high marks on their portfolios through all types of market cycles.
One of the benefits of including bonds in a portfolio is that they tend to move in a different direction than equities. This means when stocks decline, bonds typically rise or decline less. At the beginning of the year, stocks fell from record highs, contracting nearly 21% over the first quarter of the year. Meanwhile, bonds rose 1.6% over the same time period. As illustrated in the chart, stock and bond prices have frequently moved in opposite directions in the past. While stocks historically have had higher returns over the long run, bonds have outperformed stocks on a rolling one-year basis nearly one-third of the time, with much lower day-to-day volatility. Moreover, during stock market booms and busts over the past 10 years, an all-equity portfolio rose higher during the good times but also fell more sharply during the bad periods. History shows that over the long haul, a balanced portfolio with bonds and equities post similar returns than with equities alone, but with lower volatility along the way.
A source of reliable income is important to many investors, especially those who are approaching or in retirement. In addition to the income they provide, another key reason investors own bonds is for the promise of a return of principal at maturity. In today's economic environment, these key bond attributes are as important as ever. We expect the current economic weakness, low inflation and efforts by major central banks to keep short-term rates near zero, will keep bond yields low for some time to come. We also expect yields to rise once the economic conditions eventually improve. Even with low yields, an allocation to bonds is a critical component of long-term portfolios, and we recommend holding bonds until they mature or are recalled by their issuer. While bond income is generally fixed, interest rate fluctuations drive bond values.
Bond prices generally fall when interest rates rise and rise when interest rates fall. If you already own an appropriate amount of fixed income to meet your financial goals, falling rates and rising prices can increase the value of your portfolio overall. If you're seeking to add fixed income, low rates mean lower current income, but you can still benefit from the steadiness of interest payments that both individual bonds and bond funds provide, and the return of principal from individual fixed income securities.
We expect volatility to remain part of the investment landscape in 2020, as the economy weathers the economic toll of COVID-19 and we believe it will begin to rebound later this year. Diversification both within and across asset classes helps make investing a smoother ride. When it comes to bonds, owning different fixed income asset classes (e.g., Canadian investment grade, international bonds and high yield), sectors, maturities, issuers and bond categories (e.g., government, or corporate) can help stabilize portfolio returns, even during challenging economic times. For example, holding bonds of varying maturities can help lessen the impact of interest rate changes on your income and principal as the economy transitions from recession and contraction to recovery and growth. Additionally, lower quality bonds, which entail more risk, can add attractive diversification benefits to long-term investor portfolios.
Depending on your comfort with risk and long-term goals, including high-yield bonds, as appropriate, has historically provided investors with higher returns and steadier income than just equities and investment-grade bonds alone. Diversification does not guarantee a profit or protect against loss in declining markets.
With school out for the year and summer vacation well underway, it's important that investors keep the lessons they learned in early 2020. By cushioning stock market declines, providing income and adding diversification, bonds help keep investors on track in achieving their financial goals.