Owning Bonds In A Low Interest Rate Environment, Some Real Analysis

A little while back I posted about de-risking my portfolio as I get older and closer to full retirement.  I explained how I lowered my equity stake and increased my bond allocation to 25%.  And with that increase in bonds I added a TIPS fund to protect against inflation. 

I received a few snarky comments on Twitter and one email from people who think this was a less than ideal move.  All of these concerned folks had a singular theme running through their arguments – that exposure to bonds in a low interest rate environment is not wise. 

Vanguard recently issued a report that explores the equity-bond relationship in low interest environments using geeky statistical methods to get to the truth.  

The Concern

The report from Vanguard, titled Diversification still works: Exploring the equity-bond relationship with K-means clustering lays out the concern levied my way very succinctly.  They write:

The main concept underpinning the equity-bond portfolio is the idea of diversification: While equities typically offer higher returns over time, bonds’ investment properties make them an excellent tool for reducing risk. However, in recent times, investors have become more concerned about the effect of a low-interest-rate environment on the role of bonds in a portfolio. Since increases in interest rates result in bond price declines and rates are at historic lows, the worry is that bond investments can only fall in value. If that is the case, then why hold fixed income in the first place? 

Sounds pretty logical to me.  It’s not likely interest rates can go any lower, although we said that 7 years ago, and 4 years ago, and they did anyway.  But this time we mean it!  Seriously though, rates are at absurd lows and even if they do go lower it can’t be by much.  But there’s more to it than the above.

Vanguard continues:

Although this is a reasonable question, it overlooks one of the key properties of bonds: They act as a hedge against equity market drops.

And therein lies the key.  A bond investment should not solely be looked at in relation to it’s likely movement in relation to interest rates.  Bonds are a hedge against stock market declines, plain and simple.

Equities Decline

When the equity markets decline, bonds become desirable and are looked at as a flight to safety.  This is particularly true for more stable government bonds.  But the Vanguard report addresses another big factor in the equity-bond equation that’s not often discussed.  They say:

Moreover, equity market crashes themselves are often due to negative economic shocks (such as COVID-19). Central banks typically respond by cutting rates and conducting quantitative easing, which usually results in positive fixed income performance. For these reasons, investment principles would suggest that bonds still have a role to play in a portfolio. 

This is a very good point!  I vividly recall the months after 9/11 when the Fed cut interest rates numerous times to try to stop the market crash that resulted from the attacks. 

I remember this well because it prompted me to buy my house, which was the best financial decision I’ve ever made.  The 30 year mortgage rate plummeted in a short period of time, and I took advantage of it.

What A Cluster

The bulk of the Vanguard report looks at the monthly performance of government bonds and equities between 2000 – 2021.  But they further isolate the data to periods when interest rates are low, like right now.  Within these periods, their study measures how bonds perform when equities have negative performance. 

Ok, your eyes are starting glaze over.  If I start writing about their machine learning method called “K-means clustering” you might start looking for a rusty razor to plunge into your wrist.  Got it. 

If you’re a nerd like me and are so inclined, by all means read the report and look at the graphs.  It’s good stuff, albeit a bit dorky.

this image has nothing to do with the post but I took it and am quite proud of it

So What About Your Bonds?

After lots of statistical analysis including scenarios where one has more international equities versus domestic, Vanguard had this to say:

Investors have become concerned about expected returns for fixed income in a low-interest-rate environment. However, our K-means clustering analysis shows that government bonds have historically acted as a counterbalance in an equity-bond portfolio during lowrate periods by hedging against equity market drops for both U.S. and global investors. Although in some months both equities and bonds fall, our analysis suggests that this can be thought of as market noise and therefore as distinctly different from the typical outcomes, which can be regarded as recurrent equities up/bonds down and equities down/bonds up market states.

And in the end, that’s the main reason I’m invested in bonds, as a hedge against market drops, plain and simple.  I know they’re not going to outperform equities most of the time, and I also know they may well go down if interest rates increase.

It’s all about diversification and relative safety.  Thanks Vanguard for showing that my decision is backed by real data.  Of course past performance in no way predicts future results, but I’m comfortable with my decision.

*After I had this post written and ready to go, JL Collins posted about bonds with the same conclusion.