• For nearly a generation, high quality government and corporate bonds were a reliable counterweight to stocks in a balanced portfolio, bringing stability at times when stocks were anything but.
• The challenging bond market of 2022 shattered that narrative as both bonds and stocks sold off in dramatic fashion, with diversification benefits proving elusive.
• After 15 years of extremely low interest rates, the pain of 2022 constituted a rebirth of sorts, as bond yields now sit comfortably above long-term inflation rates.
• While stock and bond returns continue to largely move together, bonds did provide protection during 2024’s short-lived bouts of volatility.
• Should the economy slow, we think bonds will reassert their traditional role as a portfolio diversifier, and in the meantime we expect returns to outpace cash and short-term GICs.

For most of our careers, the value of a balanced portfolio was proven time and again – when stocks had a misstep, the bond portion of the portfolio came to the rescue and rose in value. They also dampened volatility and provided a healthy dose of income along the way. The low bond yields that prevailed after the 2008 financial crisis dampened the income, but the protection factor held strong.

2022’s bond market shocked investors used to a tranquil bond market…

That is, until 2022. The extreme monetary stimulus of the pandemic drove bond yields to record low levels, making the forward looking return path challenging unless yields went lower still. While there was some precedent for this – much of Europe and Japan saw negative bond yields for a few years – any normalization of interest rates would prove to be a challenge, and that is exactly what happened in 2022.

… but also heralded a new dawn

The pain experienced that year resulted in a rebirth of sorts for bond investors – gone were the days of sub-1% yields, and bonds were now in a position to perform once again. While the highly anticipated “year of the bond” in 2023 where many expected exceptional returns didn’t quite pan out as planned, returns since 2022 have been much more in line with historical levels. Today’s yields are high enough to protect from expected long-term rates of inflation, and just as importantly, they are high enough that there is a lot of room for them to fall (and prices rise) in the event of an economic or market shock.

Bonds now present an “asymmetric” return profile…

One of the characteristics we look for in any portfolio investment is an “asymmetric” return profile, which means the upside is much greater than the downside risk. In the stock market, this is difficult to measure, as downside can’t be readily quantified, and the range of outcomes in both directions is very wide. In the bond market, however, it is just a matter of math. We know with a high degree of certainty what the return on a bond investment will be for a given change in yields. In the current market, that risk reward is quite attractive and in sharp contrast to what we saw in 2020. As seen below, in 2020 the upside and downside risk for a 10-year U.S. Treasury bond (the global benchmark for bonds) was nearly identical for a rise/fall of 100bps (1%) in bond yields. This is because the income component was miniscule at 0.5%. Today we have a yield north of 4.5%, meaning that return is additive to any price upside and also buffers any downside. Today, the upside/downside return ratio for a 1% move in bond yields is over 4:1, largely due to the high level of current income.

…and have a long history of outperforming GICs

During the past few years of high and volatile bond yields, GICs have been a very popular choice for investors looking for cash flow and minimal volatility. With the Bank of Canada engaging in aggressive interest rate cuts, the yields on GICs are not what they used to be. As seen below, bonds have a long history of outperforming GICs (with the stark exception of the post-COVID era) as they benefit from both current income and the potential for price appreciation when bond yields are falling.

Bonds are protecting downside once again

For nearly the entire era from 2000 until COVID, bonds provided positive returns when stocks corrected sharply. That came to an abrupt end in 2022 when inflation hit and surging bond yields were the problem that was rattling the stock market. We would note that in 2024 bonds tentatively stepped back into their role as portfolio protector. While we didn’t see any corrections of the 10%+ variety in 2024, we did see a couple of sharp selloffs in the late summer and in those two instances, long-term U.S. Treasuries did indeed provide some protection against falling stocks. As seen in the table below, this is early days after five corrections in a row where bonds did not provide protection, but we need to start somewhere.

Bonds have renewed purpose in portfolios

The past few years have no doubt seen some trying times for bond investors, but in our view the pain has been worth it because we have come through in a better place. Gone are the ultra-low yields of the post-Great Financial Crisis era. Bonds now carry a reasonable rate of return, and the yields are high enough that there is plenty of room for them to fall (and prices to rise) in times of stress to buffer the volatility in stocks. In the meantime we are able to earn a yield that is better than high interest savings accounts and has typically outperformed GICs. In a year where uncertainty is already high two weeks into January, maintaining a protective element in portfolios could prove key to calming nerves when volatility eventually resurfaces.

The Harbour Group

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