Why Bonds May Be a Better Deal Than You Think

Many investors are wary of bonds these days, for good reason. Yields are pathetically low and when interest rates rise—whenever that may be—bond prices will fall. But there's a compelling reason you should still make bonds part of your investing strategy—namely, they provide a diversification benefit that may be more powerful than ever before.

To understand why that's the case, you have to be familiar with an investing metric known as correlation. Basically, correlation measures on a scale of +1 to -1 how closely the movements of two investments track each other. If two investments always move up or down at the same time, they have a correlation equal to 1. If they always move in opposite directions, their correlation is -1. A correlation of zero means there's no relationship between the movements of the two investments.

Ideally, when building a portfolio you want to assemble a group of assets that have low or negative correlations with each other. The idea is that by doing so your portfolio will be able to thrive in a variety of market conditions, as some investments rack up gains that can help offset the losses others are suffering. At the very least, your overall portfolio will be less volatile since not all your investments will rise or fall by the same amount at the same time.

So what does all this have to do with investing in bonds today? Well, a recent Vanguard blog post notes that the correlation between the Standard & Poor's 500 stock index and 10-year U.S. Treasury bonds over rolling five-year periods has fallen to or near its lowest point in the last 145 years. As of the end of July, the correlation between the two was -0.6.

When it comes to creating portfolios, getting that level of negative correlation is like hitting the diversification jackpot. "When correlations are low or negative," explains Vanguard senior economist Roger Aliaga-Diaz, "you get more diversification value from bonds." Or, to put it another way, the more likely bonds will provide at least some protection when stock prices head south.

A few caveats are in order. There's no guarantee this relationship will remain at or near historic lows, although correlations between stocks and bonds tend to stay low during periods of sluggish growth and low inflation, which pretty well describes the current economic outlook. Aliaga-Diaz also cautions that a negative correlation suggests stock and bond prices will move in opposite directions on average. But there can and likely will be instances when they move in synch. And even when bonds do move in the opposite direction of stocks, that doesn't mean they'll gain as much as stocks lose. Stocks are far more volatile and given to deeper plunges. So you should think of bonds as providing a bit of a cushion against stock setbacks, not total immunization from losses.

It's also important to remember that these correlation stats look only at the relationship between stocks and 10-year U.S. Treasuries. That said, research also shows that investment-grade bonds as a group, which includes not just Treasuries but government agency issues and high-quality corporates (though not high-yield, or junk, bonds), can also provide solid diversification during periods of stock market turbulence.

And, in fact, you probably don't want to limit your bond stake just to Treasuries, as you would be giving up the extra one to two percentage points or more of extra yield that other high-quality bonds can generate. You can easily reap the benefits of a broadly diversified portfolio of Treasuries and other investment-grade bonds by investing in a total U.S. bond market index fund or ETF that tracks a benchmark like the Barclays U.S. Aggregate bond index. In the financial-crisis year of 2008, that index gained 5.2% while the S&P 500 lost 37%. For guidance on how to divvy up your portfolio between stocks and high-quality bonds so it gives you an acceptable balance between risk and return, you can complete a risk-tolerance asset-allocation questionnaire. You'll find such a questionnaire as well as other useful investing and retirement-planning tools in the Retirement Investing section of RealDealRetirement's Retirement Toolbox.

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Of course, assuming interest rates eventually go up, your bond holdings will take a hit; there's no getting around the basic seesaw relationship between interest rates and bond prices. (When one goes up, the other goes down and vice versa.) But you can mitigate the damage somewhat by sticking to bond funds with intermediate- to short-term average maturities. You can also take a bit of solace from the fact that bonds aren't likely to suffer anything close to the dramatic losses stocks incur in bear markets. And while higher rates will erode the value of your bond funds in the short term, rising yields can actually work to your advantage longer term, as funds re-invest interest income and proceeds from bond sales and maturing bonds at higher rates.

Bottom line: There are plenty of reasons to be skittish about bonds. But a diversified portfolio of U.S. Treasuries and other high-quality bonds remains an effective way to diversify against the risks of the stock market. And in the case of Treasuries at least, they may be more valuable at delivering that benefit than ever before.

Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at walter@realdealretirement.com. You can tweet Walter at @RealDealRetire.