Bonds: There When You Need Them

January 10, 2019

The markets had a tough year in 2018 and closed the year out with a thud. The year ended with stocks slipping in the face of fears regarding trade rhetoric and global growth concerns. Equities closed the year down anywhere from 4.4% (US large stocks – S&P 500) to down 14.6% (Emerging market stocks – MSCI Emerging Markets). A broadly diversified portfolio invested in stocks across the globe was down 9.4% (MSCI ACWI).

 

Bonds had a challenging year as well, at least in bond terms. The Bloomberg Barclays US Aggregate Bond index was down 1.6% through the end of September, facing strong headwinds from a Fed trying to normalize interest rate policy and continue to push rates up. With four rate hikes in 2018, Federal Reserve Chairman Powell pushed rates up higher than many in the market anticipated. As higher interest rates cause the price of bonds to fall, bond performance suffered as a result.

 

Rate hikes, while a negative for a bond investor in the short term due to the above-mentioned price impact, are in fact a long-term benefit. The increased interest income associated with higher interest rates overwhelms the price impact over the long run, and you can see that effect with the steady climbs upwards after sharp declines as bond holders “clip their coupon.”

However, bond’s role as a diversifier to equities really showed up in the fourth quarter as sell-off in the equity markets persisted for much of the quarter, with one negative headline after another pushing equity prices down. This sell off even affected the vaunted technology sector, which had been a source of outsized returns since the financial crisis. In the first three quarters of 2018, the technology sector (as represented by the SPDR Technology Sector ETF, symbol XLK) was up 19.0%.  However, in the 4th quarter gave it all up and more, down a stunning 23.2% as of close of trading on Christmas Eve, before taking advantage of the fabled “Santa Claus Bounce” to close the 4th quarter down only 17.4%, and closing out the year in total down 1.68%.

While chaos and fear reigned supreme in the equity markets in the fourth quarter of 2018, bonds quietly did their thing. They provided stability in times of equity market stress.

 

As the S&P 500, along with other equity indices, raced downwards, bonds held firm and appreciated as people took risk off the table and moved away from equity investments into less risky assets such as bonds.

Bond’s performance in the last quarter of 2018 is a testament to the power of a diversified portfolio of stocks and bonds. While over long periods of times, stocks outperform bonds, in times of stress bonds provide a stabilizing influence. By having a reasonable allocation to bonds, investors are able to avoid having to sell out of equities at the worst times, and in fact may have the ability to use some of their bonds to buy stocks while they are on “sale.” Even more importantly, the presence of bonds in your portfolio may help you sleep at night in the face of market volatility.