2022 was an unusual year, with both bonds and stocks down at the same time. As a result, you may be questioning the role of bonds in your portfolio and considering whether to move your money from bonds to cash or short-term CDs (certificates of deposit). To help you stay on track with your long-term financial goals, we have answers to some commonly asked questions about bonds that are top of mind.
Why should I invest in bonds?
Nobel Prize-winning economist Harry Markowitz called diversification "the only free lunch in finance." Bonds have played an essential role in diversifying investor portfolios and helping to mitigate portfolio losses during periods of negative equity returns. And we believe bonds will continue to play a valuable role in offsetting stock losses over the long term.
"Diversification benefits are back," said Sara Devereux, global head of Vanguard Fixed Income Group. "2022 was a highly unusual year. Over the long term, bonds continue to be a great diversifier to equity stress."
Diversifying your portfolio across stocks and bonds can help lower your overall risk and reduce volatility. When you may be tempted to abandon your investment plan in favor of market-timing moves, it's important to remember that sticking to your asset allocation is often the best strategy for keeping your long-term goals on track.
Over the past 50 years,* bonds have delivered meaningful diversification benefits in years of negative equity returns; 2022 was an exception, not the rule.
*Data for U.S. mortgage-backed bonds begins in 1976 and is not included in the 1973 and 1974 periods.
Note: Vanguard calculations from data provided by Morningstar as of June 30, 2023. U.S. equities represented by the S&P 500. U.S. corporate bonds represented by the Bloomberg US Corp Bond Index. U.S. government bonds represented by the Bloomberg US Government Index. U.S. mortgage-backed bonds represented by the Bloomberg US MBS Index. Past performance is no guarantee of future results. The performance of an index does not represent any particular investment, as you cannot invest directly in an index.
Should I invest in bonds now?
Here are 3 reasons why now's a good time to evaluate the role of high-quality fixed income exposure in your portfolio.
Bonds are providing healthier yields than we've seen since before the 2008 global financial crisis. Higher current yields support a much-improved outlook for bond returns going forward. Higher yields can help reduce risk by acting as a buffer to additional rate increases while also providing a stronger base for future returns if the Federal Reserve begins cutting rates in the future. As a result, bonds may provide you with attractive yields at a lower risk profile than we've seen in recent years.
Higher yields can offer a cushion against rising rates and a boost against falling rates
Notes: Cash represented by the S&P U.S. Treasury Bill 0-3 Month Index with a duration of 0.08 years and a yield to maturity of 5.40%. Short-term Treasuries represented by the Bloomberg U.S. Treasury 1–3 Year Index with a duration of 1.88 years and a yield to maturity of 4.92%. Intermediate-term Treasuries are represented by the Bloomberg U.S. Treasury 3–10 Year Index with a duration of 5.06 years and a yield to maturity of 4.28%. Long-term Treasuries are represented by the Bloomberg U.S. Long Treasury Index with a duration of 15.70 years and a yield to maturity of 4.34%. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. Scenario assumes any interest rate changes occur at the beginning of the period and before any reinvestment of dividends. Scenario does not take convexity into account. In this example, we apply the principle of duration as a measure of interest rate sensitivity to consider the impact of future rate changes on bonds and cash. This illustration is hypothetical and does not represent the return on any particular investment, and the rate is not guaranteed.
2. After a year like 2022, it may be tempting to wait in cash for the right moment to reinvest in bonds. But predicting the path of interest rates is notoriously hard to do, and nobody can be sure if we've reached peak interest rates in the Federal Reserve's march to contain inflation. The decision to shift your long-term portfolio from bonds to cash comes with risks to your long-term financial goals. Over long time periods, bonds have provided better returns than cash. And as history has shown, they've also outperformed cash in the 3-year period following peak rate hikes dating back to 1980.
Bonds typically outperform cash in the 3 years following peak federal funds rates
Notes: Cash is represented by the U.S. 3 Month Treasury Bill auction rate. U.S. aggregate is represented by the Bloomberg US Aggregate Bond Index. U.S. corporate is represented by the Bloomberg US Corporate Bond Index. U.S. government is represented by the Bloomberg US Government Bond Index. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Sources: Vanguard calculations, using data from Vanguard, Morningstar, and Bloomberg as of August 31, 2023.
3. Strong bond returns relative to cash can also be seen during recessions since 1980. "While it's always possible that the next recession features a different pattern of relative returns, it pays to remember that bonds have tended to outperform during recessions," said Sara Devereux.
Bonds have historically performed better than stocks and cash during recessions
Note: Stocks represented by the S&P 500 Index. Bonds represented by the Bloomberg US Aggregate Bond Index. Cash represented by the U.S. 3 Month Treasury Bill auction rate. Recessions are measured by the National Bureau of Economic Research (NBER). Past performance is no guarantee of future results. The returns of an index do not represent any actual investor performance as one cannot invest directly in an index.
Sources: Vanguard calculations based on data provided by Morningstar, Standard & Poors, Bloomberg, and the U.S. Treasury as of August 31, 2023.
Should I consider moving from bonds to cash?
When it comes to your asset allocation, cash is a great option to meet shorter-term spending needs or goals like building your emergency savings. But for your longer-term goals, you may want to consider taking advantage of the benefits bonds bring to a balanced portfolio.
Short-term market-timing moves can put your portfolio at risk because the future path of interest rates is nearly impossible to time. Over the long term, high-quality bond funds have tended to offer better diversification against stock volatility and higher yield potential than cash.
While the road ahead may be a bit bumpy, sticking to your investment plan is an important step toward keeping your long-term goals on track.You can consult a tax or financial advisor about your individual situation.
Important information
All investing is subject to risk, including the possible loss of the money you invest. The performance data shown represent past performance. Past performance is no guarantee of future results.
There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.
Diversification does not ensure a profit or protect against a loss.
Publication date: February 2024
The information contained in this material may be subject to change without notice and may not represent the views and/or opinions of Vanguard Investments Canada Inc.
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