Do Bonds Still Work?
Diversifying sufficiently among uncorrelated risks can reduce portfolio risk toward zero.
Diversifying your portfolio is one of the most important things you can do to manage investment risk. A properly diversified equity exposure helps to take away the systemic risk of owning a handful of individual companies. Within an asset allocation, diversified bonds within the investment grade spectrum are commonly used to help reduce volatility and risk against stock market dips.
But with the end of easy money policies from central banks around the world and expectations of rising interest rates, you may be wondering — Should bonds play a role in my investments? In this environment, why hold bonds at all?’ — In addition to the wealth of existing peer reviewed academic evidence, a recent machine learning analysis by Vanguard may help to provide some insights.
Researchers from Vanguard applied a machine learning technique called “K-means clustering” to periods when rates were low. Results showed that government bonds have historically acted as intended in an equity-bond portfolio, performing positively when equities have fallen. Whilst there were periods where both equities and bonds fell, this phenomenon was part of market volatility.
The chart below shows this clearly - market data of global equities and global bonds represented by the MSCI All Country World Index and Bloomberg Barclays Global Treasury Total Return Index were taken from Oct 2000 to Mar 2021 and only for periods where the bond yields were below 1.5%. The machine was then asked to classify the data in 2 clusters and 4 clusters.
In the chart above, you will notice a blue and grey cluster. The grey cluster represents the times where equities have had positive performance while bonds were slightly negatively tilted. The blue cluster shows that where bonds had positive performance and equities have almost always been negative. This suggests a negative relationship between equities and bond returns. In addition, you do not see any clusters forming when both equities and bonds are negative.
In this second chart below, the K-means cluster is now split into 4. The blue cluster is one where equities were clearly negative and bond returns positive. The purple cluster is where equities straddled between being slightly positive and negative and bond returns were generally positive. The green cluster shows periods the data points where equities were mainly positive, and bond returns were negative. Finally the grey cluster shows the other extreme where both equities and bonds were positive. In this representation, again, there is no cluster occurring where both equities and bonds were negative.
For the geeks amongst us, a key advantage of this analysis over a regression approach is the identification of market states. In addition to providing information on the relationship between equities and bonds, K-means enables researchers to identify any clustering that may be consistent with the presence of a specific market state, such as the one we wanted to test where both equities and bonds were down. The combination of the optimal number of clusters and their locations helps the researchers to assess whether there is sufficient evidence for such a state to exist.
Many of us have become worried about potential bond losses in an environment where interest rates are likely to rise. This can lead to investors questioning the need for bonds in their portfolios and the value of asset allocation. However, a look at the relationship between bond and equity returns during low interest rate environments using K-means clustering shows that investment grade government bonds continue to play their role by hedging against equity market drops for investors. All the portfolios that we currently construct and run for our clients have allocations to these type of bonds specifically for this purpose.
While there are occasional periods where both equities and bonds can suffer a loss, it is few and far between and can be considered as part of market noise. If you are worried about the investments you currently hold and whether it can withstand the impact of a rising rate environment, drop us a note and we will be more than happy to discuss it together with you.
