About once a week, someone will say, “I don’t understand bonds.” Sometimes they’ll state it in stronger terms: “I don’t like bonds.” So it’s worth taking a closer look.
Fundamentally, bonds are just IOUs. If you buy a $1,000 U.S. Treasury bond, you’re simply lending the government $1,000. The Treasury will then pay you interest twice a year and return your $1,000 when the bond matures. That part is straightforward. What’s more of a mystery, though, is why we should own bonds, and what we should expect from them.
In a recent article, investment researcher Ben Carlson highlighted why this is such a mystery. In short, Carlson argued, the way investors tend to think about bonds doesn’t match the data. Specifically, bonds have a reputation for moving inversely with stocks. When stocks go down, bonds tend to go up. This is known as negative correlation, and it’s the reason why stocks and bonds tend to work so well together. In 10 out of the past 50 years, the stock market has lost value on an annual basis. And in nine out of those 10 years, bonds gained value. That’s been a tremendous benefit.
Investors sometimes refer to this as a “flight to safety.” When the stock market drops, investors turn to the security of bonds, and that pushes bond prices up. We saw this as recently as a month ago. As you may recall, in early August the stock market dropped briefly, in response to a weak unemployment report and other factors. In total, the stock market dropped 6% in three days. And in those three days, bonds rose, gaining almost 1.5%. It was a perfect example of portfolio diversification. For many investors, this is reason enough to own bonds. In fact, I often describe bonds as being like insurance. They’re there to carry investors through periods when the stock market is down.
But Carlson, the researcher, argues that we’re not giving bonds enough credit. Seeing bonds only as insurance ignores their performance the rest of the time. And the fact is that bonds have delivered generally steady and positive returns through most market environments—not just during periods when the stock market has been down. Bonds, in fact, have delivered positive returns in 44 of the past 50 years. And while those returns have been lower than the returns on stocks, they’re not immaterial. On average, between 1974 and 2023, bonds returned 6.3% per year. Bonds, in other words, aren’t just insurance.
But you might wonder how this is possible. If bonds are inversely correlated with stocks—rising when stocks fall—then doesn’t that mean that bonds should fall when stocks rise? This is where bonds’ reputation is a bit misleading. What the data show is that stocks and bonds are only sometimes negatively correlated. More often, the correlation hovers around zero, meaning that there is no strict pattern to how stocks and bonds trade in relation to each other. Recent data illustrates this.
According to J.P. Morgan, over the past 10 years, through June 30, the correlation between stocks and bonds has been slightly positive, at 0.32. But over the 10 years ending June 30, 2021, the correlation was slightly negative, at -0.21. In other words, bonds and stocks generally exhibit no consistent correlation—except in times of crisis. And that’s when the correlation does turn negative fairly reliably. During the early part of the pandemic in 2020, for example, short-term bonds rose when the stock market fell. This dynamic makes bonds an excellent tool for diversification.
Another lesson in the data: It’s important to be aware of the risk posed by recency bias—that is, the tendency to extrapolate from recent experience. In recent years, many investors have soured on bonds, but it’s important to recognize that this has been an unusual period. Why? When the Fed dropped interest rates in response to Covid in 2020, yields on bonds and cash both dropped in tandem. For a time, both were near 0%. That made bonds and cash seem interchangeable, and equally unappealing. Then, when the Fed began raising interest rates in 2022, rates on many savings accounts rose quickly to the 4% or 5% range. Meanwhile, bonds lost value, with the most popular bond index down more than 10% in 2022. So for the past few years, cash has looked like a better bet than bonds. But this has been an unusual period, and there’s no reason to expect it to continue. In most years, bonds have delivered considerably higher returns than bank savings accounts. Indeed, with the Fed now signaling that it is ready to begin lowering rates again, this is a good time to review your holdings.
If you’ve been stockpiling cash, benefiting from today’s high rates, you might consider moving some of that over to the bond side. Not only will that position you to capture the bond market’s generally higher returns relative to cash, but it will also position you to benefit from the price appreciation that typically lifts bonds when interest rates fall. And even though the Fed hasn’t formally lowered rates, market rates are already starting to adjust. Since 2022, short-term interest rates have been higher than long-term rates—a situation known as an inverted yield curve—but just this week, that reversed. This is a sign that we may be entering a more normal period, where bonds will deliver better returns than cash.
As you review your bond holdings, what else should you consider? In the discussion so far, I’ve been referring to the bond market in general terms. But some bonds are much more highly correlated with stocks—and thus offer less of a diversification benefit—than others. Corporate bonds, and especially high-yield corporate bonds, tend to exhibit strong positive correlation with the stock market, making them less useful as a diversifier than Treasury bonds and municipal bonds.
Another way in which bonds differ from one another is in their maturities. Intermediate-term bonds will tend to lose more value than short-term bonds when interest rates rise and to gain more value when rates fall. Today, with rates starting to fall, intermediate-term bonds have more to gain. But to guard against future interest rate changes—which could go in either direction—I’d hold a mix of both short- and intermediate-term bonds. What about long term bonds? In my view, they carry far too much risk and are easy to exclude from a portfolio.
