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Why Bonds Still Matter

Do bonds still provide adequate diversification? That was the question many investors were asking in March 2020 when bonds and stocks sold off at the same time—before the Federal Reserve stepped in to calm markets.

In fact, some have gone so far as to proclaim that the “traditional” portfolio of 60% stocks and 40% bonds is no longer optimal. We believe such concerns are overblown for three reasons:

  1. Even when offering very low yields, intermediate-term U.S. Treasuries generally have held their value or appreciated during significant stock market declines—a trend that was borne out amid last year’s turmoil. On the other hand, short-term Treasuries—which are considered a cash equivalent—have failed to provide a similar hedge (see “A port in the storm,” below).
  2. Despite the blip last spring, Treasuries continue to demonstrate negative correlation with stocks over the short and medium terms, helping cement their status as a safe haven during times of market stress—and there’s no clear alternative to fill that role.
  3. The 60/40 split was never right for everyone, since the right mix of asset classes for your particular portfolio has more to do with your specific goals and capacity for risk.


A port in the storm

Over the past 30 years, intermediate-term Treasuries have provided a better hedge against market declines than short-term Treasuries.

 

Source: Schwab Center for Financial Research, with data from Morningstar. Intermediate-term Treasuries are represented by the Ibbotson U.S. Intermediate-Term Government Bond Index and T-bills are represented by the Ibbotson U.S. 30-day Treasury Bill Index. Dates represent the start of commonly accepted bear markets (periods during which the S&P 500® Index declined at least 20%), plus September 2018 (when the S&P 500 fell 19%). Past performance is no guarantee of future results.


Beyond diversification

Diversification benefits aside, the high returns seen from intermediate Treasuries last year aren’t likely to be repeated over the next few years. Starting yields for fixed income investments are a reliable barometer of future returns over the long run, and bond yields are currently near or at historic lows.

However, we do see the potential for 10-year Treasury yields to rise to the 2% level in the coming months—even as the Fed keeps short-term interest rates near zero—assuming the economy continues to recover. Consequently, we suggest reducing the overall duration in your portfolio to mitigate the risk of rising long-term interest rates, while maintaining an allocation to intermediate-term bonds for their diversification benefits. (Duration is a measure of the sensitivity of bond prices to changes in interest rates.)

Indeed, you might consider holding a mix of short- and intermediate-term bonds to manage the effects of rising interest rates. Short-term bonds provide the flexibility to reinvest if rates rise, while longer-term bonds provide stable yields that can help offset the effects of another round of market turmoil.

Alternatively, you could use a bond ladder—a portfolio of individual bonds or certificates of deposit that mature at regular intervals—which also allows you to reinvest the proceeds from maturing bonds in higher-yielding bonds once interest rates move up.

Beyond 60/40

If the traditional 60/40 stocks-to-bonds allocation isn’t optimal, what’s an investor to do? For one, make sure your portfolio allocation matches your risk tolerance and goals rather than a supposedly one-size-fits-all target allocation.

Beyond that, we suggest broader diversification across all asset classes, not just bonds. Our anticipated returns for both bonds and stocks are lower for the next 10 years than over the past 50 years, due in part to high starting valuations and low inflation projections (see “Lower your expectations,” below). As a result, we suggest exposure to a wide array of global asset classes to help manage risk and provide a broader set of investment opportunities.


Lower your expectations

Returns for all asset classes are expected to be lower over the next decade.

Source: Charles Schwab Investment Advisory and Morningstar Direct. Data as of 03/31/2020. Indexes representing the investment types are: S&P 500® Index (U.S. large-cap stocks); Russell 2000® Index (U.S. small-cap stocks); MSCI EAFE Index (international large-cap stocks); Bloomberg Barclays U.S. Aggregate Bond Index (U.S. investment-grade bonds); and Bloomberg Barclays 1–3 Month U.S. Treasury Bill Index (cash investments). Past performance is no guarantee of future results.


Within fixed income, we still believe most investors should allocate the bulk of their portfolios to what we consider “core” bonds (think Treasuries and highly rated corporate and municipal bonds) for stability and capital preservation—but also include exposure to riskier investments like emerging-market bonds, high-yield corporates, and preferred securities, assuming you can tolerate the higher volatility that typically accompanies them.

And while we don’t expect inflation to be a significant problem over the next few years, we believe holding some inflation-linked bonds, such as Treasury Inflation-Protected Securities (TIPS), makes sense, to mitigate the risk of an unexpected spike in inflation.

What You Can Do Next

Schwab Intelligent Portfolios® can build and manage a globally diversified portfolio of low-cost exchange-traded funds, along with a cash allocation, based on your goals and risk tolerance. Learn more.

Important Disclosures

Please read the Schwab Intelligent Portfolios Solutions™ disclosure brochures for important information, pricing, and disclosures related to the Schwab Intelligent Portfolios and Schwab Intelligent Portfolios Premium programs.  Schwab Intelligent Portfolios® and Schwab Intelligent Portfolios Premium™ are made available through Charles Schwab & Co., Inc. (“Schwab”), a dually registered investment advisor and broker dealer.

Portfolio management services are provided by Charles Schwab Investment Advisory, Inc. (“CSIA”). Schwab and CSIA are subsidiaries of The Charles Schwab Corporation.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. High-yield bonds and lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

Treasury Inflation Protected Securities (TIPS) are inflation‐linked securities issued by the US Government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. Thus, the dividend amount payable is also impacted by variations in the inflation rate, as it is based upon the principal value of the bond. It may fluctuate up or down. Repayment at maturity is guaranteed by the US Government and may be adjusted for inflation to become the greater of the original face amount at issuance or that face amount plus an adjustment for inflation.

Diversification and asset allocation strategies do not ensure a profit and do not protect against losses in declining markets.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Investing involves risk, including loss of principal.

Indexes are unmanaged, do not incur management fees, costs, and expenses, and cannot be invested in directly. For more information on indexes please see schwab.com/indexdefinitions.

Correlation is a statistical measure of how two investments have historically moved in relation to each other, and ranges from -1 to +1. A correlation of 1 indicates a perfect positive correlation, while a correlation of -1 indicates a perfect negative correlation. A correlation of zero means the assets are not correlated.

A bond ladder, depending on the types and amount of securities within the ladder, may not ensure adequate diversification of your investment portfolio. This potential lack of diversification may result in heightened volatility of the value of your portfolio. You must perform your own evaluation of whether a bond ladder and the securities held within it are consistent with your investment objective, risk tolerance, and financial circumstances.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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