Bond risk: A theory of relativity

Posted by on September 30, 2013 @ 9:15 am in Economy & markets

Risk is a relative term. If someone asked you to set aside $150 a month, possibly with no return on your investment, you’d probably say, “No way!” Yet what if you knew the alternative was losing your home and all of your belongings in a fire, flood, or other emergency, with no funds to help rebuild your life? Suddenly, the $150-per-month payment for disaster insurance might seem like a good idea.

The same perspective can apply to bonds. If you’re considering an allocation to bonds but have been warned that this allocation may have low or even negative returns in the next few years, you may see bonds as a risky bet. Yet by weighing the risks of the alternative—that an allocation to equities is far more likely to experience highly negative returns of –5% or more during the same period according to output from Vanguard’s Capital Markets Model—you may begin to recognize bonds as the steady diversifier and volatility dampener they truly are when combined with a stock portfolio.

The calculation of bond returns is highly mathematical in nature, and right now the equation isn’t pretty. Output from the Vanguard Capital Markets Model® (VCMM)* suggests that the most likely annualized return scenario for bonds over the next ten years will be in the range of 1.5% to 2.5%. This is considerably lower than the long-term historical average** for bonds of 5.6% through the end of 2012. This disappointing bond performance may be a rude awakening for clients coming off the 30-year bond bull market.

However, before abandoning bonds in search of higher-yielding securities or those with greater potential for returns, you should consider the corresponding risks. In the chart below, you’ll see that, when considering the relative risks of bonds and equities, in addition to the issue of whether these asset classes face a risk of loss, you must consider the potential magnitude of the loss. While bonds may have a higher probability of low or negative returns over the next few years, they have a relatively low risk of experiencing the magnitude of losses equities are susceptible to. In the rolling 12-month periods shown below, there were 211 instances when equities saw returns of –5% or less but only 30 instances when bonds had losses of the same magnitude.***

Relative risk of loss in equities and bonds over a rolling 12-month periods

Historicalreturns_082013

Notes: Returns are year over year presented on a monthly basis.
Source: Vanguard. For U.S. bond market returns, we used the S&P High Grade Corporate Index from 1926 through 1968, the Citigroup High Grade Index from 1969 through 1972, the Lehman Brothers U.S. Long Credit AA Index from 1973 through 1975, and the Barclays U.S. Aggregate Bond Index thereafter. For U.S. stock market returns, we used the S&P 90 Index from 1926 through March 3, 1957; the S&P 500 Index from March 4, 1957, through 1974; the Dow Jones Wilshire 5000 Index from 1975 through April 22, 2005; and the MSCI US Broad Market Index thereafter.

In addition to lessening the potential losses in an equity portfolio, bonds have other properties that make them a good diversifier. In Reducing bonds? Proceed with caution, Fran Kinniry and Brian Scott conclude that bonds’ low correlation with equities means they will likely continue to provide a cushion in periods of negative equity returns. The slightly negative or slightly positive returns from your bond allocation, while nothing to write home about in terms of income generation, should help cushion portfolio losses in a poor equity market. Compare this soft landing with a portfolio that has substituted assets such as high-dividend stocks, REITs, and high-yield bonds for traditional bonds in search for yield. As the chart below shows, such asset classes have experienced relatively large losses before, particularly during the tumultuous equity bear market from October 2007 to March 2009, diminishing their diversification potential when it was needed most.

Diversification matters most during flight to quality

Cumulative performance of selected market segments, October 2007–March 2009

riskLoss_082013

Sources: Vanguard and Thomson Reuters Datastream.
Notes: Returns for U.S. stocks, international stocks, and REITs represent price returns. Returns for commodities and bonds represent total returns.
Benchmarks: U.S. stocks, MSCI US Broad Market Index; international stocks, MSCI World ex USA Index; emerging markets stocks, MSCI Emerging Markets Index; REITs, FTSE NAREIT U.S. Real Estate Index; commodities, Dow Jones-UBS Commodity Index; emerging markets bonds, J.P. Morgan Emerging Markets Bond Index Global; high-yield bonds, Barclays U.S. Corporate High Yield Index; investment-grade corporate bonds, Barclays U.S. Corporate Index; Treasury bonds, Barclays U.S. Treasury Index.

Of course, bonds may not offer the same level of protection as they did in the past. We likely won’t see the 15% returns in Treasury bonds that appear in the above chart anytime soon.

But remember that this potential disappointment is merely relative: The cushion may not be as deep as before, yet you would likely prefer the reality of underperforming bonds to a world in which all asset classes in their portfolios moved down at the same time and by a similar magnitude. For that reason, Vanguard still believes in the diversification value that bonds provide investors during rough periods of equity returns.

For more on this topic, see our recent research titled Risk of loss: Should the prospect of rising rates push investors from high-quality bonds?

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*Historical series of asset class returns and economic variables serve as inputs for the VCMM, which then uses the current conditions of these variables along with their modeled interrelationships to provide users with 10,000 potential paths for the returns of several asset classes under various economic conditions.
**Long-term returns are the average monthly U.S. aggregate bond market annualized returns since 1926.  In defining the aggregate U.S. bond market, we used the Standard & Poor’s High Grade Corporate Index from 1926 through 1968; the Citigroup High Grade Index from 1969 through 1972; the Lehman Brothers U.S. Long Credit AA Index from 1973 through 1975; and the Barclays U.S. Aggregate Bond Index thereafter.
***In defining the U.S. stock market, we used the Standard & Poor’s 90 from 1926 through March 1957; the Standard & Poor’s 500 from April 1957 through 1974; the Dow Jones Wilshire 5000 from 1975 through April 2005; and the MSCI Broad Market Index thereafter.

Notes:

Investments in bonds are subject to interest rate, credit, and inflation risk.

Past performance is no guarantee of future returns.

All investing is subject to risk, including possible loss of principal.

Diversification does not ensure a profit or protect against a loss.

IMPORTANT: The projections or other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.

The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.

The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then

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