Vanguard has a great chart in their latest ETF Perspectives newsletter that gives you a good idea about where risk usually lies during a severe stock market sell-off:
Vanguard highlighted high-yield bonds to show how they typically perform worse than other types of bonds during a stock market drop. There are many investors out there who are nervous about bonds at these interest rate levels, and rightly so. Interest rate risk is worth considering since volatility is heightened at lower yield levels. But I think investors are forgetting the kind of emotional hedge that high-quality bonds can provide during a stock market route.
Obviously, everyone has a different appetite for risk and some can handle the increased volatility more than others. The bond bull market may be coming to an end (it has to eventually, right?), but I think it’s a mistake for risk-averse or diversified investors to completely give up on high-quality bonds because they’re worried about poor returns from low yields. It’s just not going to be as easy in fixed income as it has been in the past.
I was on SiriusXM radio for an interview with Jeremy Schwartz of WisdomTree last week and the other guest on the show was an unconstrained bond fund manager from Western Asset Management. During our talk, I shared with this portfolio manager that I don’t envy his position in the coming years. Investors are infatuated with the stock market, but I actually think that bonds are going to be even more interesting over the coming decade or so.
There’s really no place to hide. If you’re looking for higher-yielding securities, prepare yourself for the probability of more volatility and larger drawdowns. If you’re looking for safety and a lower probability for losses during stock market corrections, high-quality bonds should still prove to help more often than not. But, as I shared with Jeremy, there is a legitimate possibility that we could see both stocks and bonds down during the same year at some point in the near future. Are investors prepared for that scenario?
And think about this for a minute — high yield bonds were basically created in the mid-1980s by Michael Milken and his team at Drexel Burnham. Although there have been many ups and downs in this extended rate cycle, junk bonds and the portfolio managers who buy and sell them have never experienced a rise from these yield levels before. It really is uncharted territory. The dispersion in bond fund returns has been fairly narrow compared to stock funds in the past, but I think there could be a much greater dispersion going forward as certain investors will be able to navigate the challenging fixed income environment better than others.
There will be no more wind at a bond investor’s back from consistently declining interest rates anymore. The bond market is going to start getting interesting. Buckle up.