The Role of Bonds
by Justin Eccleston
When yields decline on high-quality bonds, it’s common to look elsewhere to achieve higher yields. Oftentimes investors seek higher income by extending the duration or lowering the credit quality of their bond portfolio. Typically, lower quality bonds are more correlated to equity markets, especially during downturns. During these times the diversification benefits of high-quality bonds such as treasuries and municipals are most obvious (see chart below). The value of these bonds is often less about the returns they may provide in normal times than the returns they can provide during abnormal ones. Even when yields are low the diversification rewards from bonds can be high.
Bonds typically will lose their value when interest rates are moving higher. At times like this it’s important to remember the role of global diversification. When concerns about domestic bond prices emerge, divesting from bonds isn’t the answer but diversifying by investing in international bonds may be. The chart below shows various local risk factors, such as inflation, economic stocks, and central bank policy. Generally this resulted in less than perfect correlations of interest rates across regional bond markets. This suggests that a global approach to a fixed income allocation can provide greater diversification benefits that domestic bonds alone cannot.