The answer to this question is best answered by looking at the pros and cons. First, the pros! Most importantly, in general, bonds have historically been negatively correlated to stocks and thus serve as a good diversifier to risky stocks in a portfolio. In other words, when stocks go down, bonds would go up. However, in today’s market bonds are much less negatively correlated to stocks than historically. For example, in 2019 broad core bonds had a negative correlation coefficient of -0.31, whereas so far in 2020 the correlation coefficient core bonds to stocks actually turned slightly positive to +0.15. Consequently, bonds still serve as a risk diversifier in a portfolio, but somewhat less so today than historically.
Secondly, not all bonds are the same and their features can be tailored to the needs of a portfolio. There are many different types of bonds with different issuer and risk profiles, term structures, and collateral types. For example, U.S. Treasury bonds are generally considered a risk-free investment; they will always pay the stated coupon and par value at maturity. Corporate bonds, however, issued by corporations have “credit” risk and could default on their coupons or par value if they declared bankruptcy. High yield, or “junk”, bonds are issued by corporations with less secure balance sheets and, because of their increased credit risk, provide a higher yield than investment grade bonds to offset the increased risk.
What are the cons? As already noted, yields are so low that it is hard to justify holding a U.S. Treasury bond as an income investment, but higher yielding bonds like investment grade corporate and junk bonds could make sense if one is willing to take on some credit risk of the bond issuer. For example, the “spread” of high yield bonds on top of U.S. Treasuries today is about 5.00%; a decent premium to offset the risk of default. With 10-year Treasury yields at 0.75%, junk bonds on average yield about 5.75%.
Also, since yields are already so low and the Fed has already strongly indicated that it would not support a “negative” interest rate environment, there is a “zero-bound” interest rate floor for interest rates. This means there is almost no potential for upside price appreciation due to a decline in rates (bond prices move inversely to interest rates). In fact, the current yield to maturity of a bond is an estimate of its potential total return over its horizon. Consequently, the 10-year U.S. Treasury bond with a 0.75% yield to maturity is expected to return only 0.75% over the next 10 years; not something to be too excited about, for sure!
Other factors come into play when evaluating the usefulness of bonds, though. From a supply and demand perspective, there are many bond investors, like insurance companies and pension plans, that will continue to buy bonds regardless of the cons listed primarily because they are managing their investments against liabilities that require regular interest payments and stable par value at maturity. The underlying liabilities dictate the need for the characteristics that different types of bonds provide. Likewise, individual clients who have a liability stream that they want to support will be willing buyers of bonds to cover that need.
There are alternatives to bonds, of course. Cash comes to mind, but the yields on cash are even lower at essentially zero. High dividend stocks are another alternative to bonds and they provide a large pickup in yield. For example, a popular high dividend stock exchange-traded fund, iShares Select Dividend ETF (DVY), has a recent yield of 4.72%, but is much riskier than bonds and subject to price volatility and reduction in dividends. Real estate, energy limited partnerships, and bank loans are other places to find yield but all involve more risk.
As always, a broadly diversified portfolio managed to an appropriate risk target is the best way to manage this bond conundrum. Buy bonds, but buy them carefully and within a total portfolio context.
