It is a tenet of modern portfolio theory to allocate capital in a balanced portfolio to low-risk fixed-interest securities (bonds) to protect against exposure to more risky growth assets like equities. Some suggest as a rule of thumb to allocate capital to bonds in line with your age. The rationale for this is that the older you are, the fewer risk assets you should be owning. Bonds (a contractual obligation on behalf of the creditor to pay the debtor) are less risky than equities (a claim on an asset) and the idea is that allocating capital to bonds will protect the investor against market turmoil or financial crisis.
But is this really true? Is it really sensible to assume that an allocation to bonds will hold steady when markets decline violently? Let’s assume that you have one million euros, allocated 50% to equities and 50% to bonds. If the market were to drop by half, you would on paper have lost 250,000 euros, correct? I say ‘on paper’ because you lose nothing until you sell, locking in a real loss.
This example assumes that the bond element will hold. But will it? We simply do not know. Bonds may fall further, increasing the loss, or they may rise, offsetting the loss. In the above example, what affects the price movement of bonds is: a) the immediate cause of the stock market decline; and b) the types of bonds held by the investor.
Morningstar data for the vicious 2008 market decline shows that during the period when the US equity market fell most sharply, the high yield corporate bond market fell heavily with it. This happened as investors sold the debt of companies most vulnerable to default. Investment grade debt also fell along with equities, although not as much. In both these cases, holding high-yield bonds and some investment-grade debt would not have protected the investor, but would have increased the loss.
In contrast, US Treasury bond prices rose substantially when equities declined. Investors sought a safe haven from the chaos pushing up prices and allowing holders of US Treasuries to offset equity losses. US Treasury bonds provide investors with full faith and credit from the US government, by far the largest and most liquid bond market in the world. For investors with a sterling bias, UK government bonds (gilts) would have afforded some protection. For investors with a Euro bias, German government bonds, considered the safest paper in Europe, would also have provided a level of protection.
What bonds you hold will determine your level of protection during a severe market downturn. Sensible investors will examine carefully what type of bonds they hold and why they hold them, before concluding whether bonds offer the desired protection within their overall portfolio.
Jeremy Blatch TEP