Owning bonds has gotten a bad rap lately and it’s easy to see why. With government bond yields hovering near 0% over the last decade, it’s difficult to justify owning bonds especially with the prospect of interest rate hikes on the horizon and with the stock market continuing to hit new highs every year. Add in a healthy dose of inflation on top of a 0% yield and you might actually be losing money in real terms. So in today’s low interest rate environment, why should you continue to hold bonds in your portfolio?
In order to answer that question, let’s examine a hypothetical scenario. Take two assets as highlighted in the following table. Asset A is your typical diversified equity asset like an S&P 500 ETF (SPY). Asset B is a hypothetical negative returning, highly volatile asset like an investment in VIX futures.
|S&P 500 (Asset A)||VIX Futures (Asset B)|
Given the choice of investing in one or both of the assets, which would you pick? Most people would pick the S&P 500 ETF. After all, why would anyone want to own VIX futures when the returns are negative, especially when the volatility is so high?
But returns are only one component of portfolio construction. Portfolio volatility, and more broadly risk exposure, is the other. The crux of modern portfolio theory is the concept that diversification can increase the risk-adjusted returns of a portfolio even if one or more of the invested assets exhibits negative returns. Why do risk-adjusted returns matter? Because all investments involve risk and returns are never guaranteed. A rational investor will always choose an investment that leads to a safer portfolio over one that leads to a riskier portfolio if the resulting portfolio returns are equal.
The chart below highlights a scenario where we simulate the growth paths of the S&P 500 ETF (Asset A) and VIX futures (Asset B) as well as a portfolio that consists of half of each. For visual simplicity, we've simulated the growth of Assets A and B as wave functions mimicking the returns, volatilities and correlation in the table above.
Examining the chart, we should note the large volatility of both Assets A and B. But combining Assets A and B into one portfolio results in a nearly straight, upward-trending line. This phenomenon occurs because the correlation between Assets A and B is substantially negative. Thus, by combining two negatively correlated assets, we’re able to significantly reduce the volatility of the portfolio. And though the return of the combined portfolio is less than the S&P 500 ETF alone, the risk-adjusted return is much greater as measured by the Sharpe Ratio.
|S&P 500 ETF (A)||VIX Futures (B)||A & B Combined|
I prefaced this discussion in the context of bonds, but we've used VIX futures to more dramatically illustrate how correlation between assets can affect portfolio volatility. In reality, the correlation of a diversified portfolio of bonds to stocks is somewhere closer to zero under most market conditions. This means that you won’t quite see the exaggerated improvements in risk-adjusted returns that our example indicates, yet the underlying premise is still valid. While earning substantive returns from your bond allocation is nice, negative real returns do not diminish the effectiveness of bonds in reducing portfolio volatility. Bonds are still a unique asset class that should continue to occupy a portion of your portfolio.
And for the record, I don't recommend that an investor go out and buy VIX futures or even the VIX ETF (VXX) with the intention of mirroring the results provided here. These instruments are highly complex and can yield unpredictable results in the wrong hands. I do recommend that investors hold a portion of their portfolio in bonds if they desire lower volatility than a portfolio full of stocks.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.