Morningstar - Q2 2021 - 28

Spotlight: Role of Bonds

As the market sell-off ground on, however,
a disconcerting phenomenon unfolded. Despite a
few days of head-scratching downdrafts, Treasury
bonds stayed aloft amid a flight to quality, as
previous examinations of asset-class correlations
suggested would be the case. But high-quality
corporate bonds fell in value, taking many
bond funds down with them. Municipal bonds also
dropped. And, of course, lower-quality bond
types-junk bonds and bank loans, for example-
also plummeted, thanks to their economic
and equity market sensitivity.
All of that volatility had some market watchers
questioning the worthiness of bond funds
in investors' portfolios, especially for retirees who
are actively drawing upon their portfolios for
living expenses.
As we now know, unprecedented monetary
and fiscal stimulus paved the way for a rebound
in credit, and all fixed-income Morningstar
categories generated positive returns in 2020.
Long government funds led the way, with an
average return of 17.5%. The Bloomberg
Barclays U.S. Aggregate Bond Index, a proxy for
typical U.S. core bond exposure, returned
7.5% for the year, not far below its 8.7% return
in 2019's far less rocky environment.
Still, with historically low yields and last year's
volatile episodes, it would be no surprise
if some investors are reconsidering bonds' role
in their portfolios. After all, in the context
of diversification and building the optimal asset
allocations, bonds are supposed to be the
portfolio's shock absorber.
In this article, we'll take a deep dive on
how correlations between bonds and other asset
classes changed in 2020 and what those
changes mean for investors trying to build welldiversified portfolios. We also dig into the
diversification benefits of adding taxable bonds
and municipal bonds to a U.S. equity portfolio
and then discuss the role that time horizon
plays in deciding which types of bonds to buy.
Investing's " Free Lunch "
Diversification has often been called the only free
lunch in investing. In his landmark 1952 article

Morningstar Q2 2021

" Portfolio Selection " (which appeared in The
Journal of Finance), economist Harry Markowitz
first established that a portfolio's risk level
isn't just the sum of its individual components;
it also depends on correlation, or how the
holdings interact with each other.

versus equities and trended down for 2020 overall.
This probably reflects the sharp divergence
between riskier and less risky assets, which
became more extreme as investors fled stocks for
the relative safety of high-quality bonds early in
the year, then embraced risk later on.

Correlation is a statistical measure that captures
how two securities move in relation to each
other. A correlation coefficient of 1 means the two
have historically moved in lockstep in the
same direction, while a coefficient of negative
1 means they've moved in lockstep but in
opposite directions. A correlation coefficient of
0 means the two securities have historically
had no relationship.

To learn more about the diversification benefits of
taxable bonds and municipal bonds, we'll
take a closer look at not only what happened in
2020 but also at longer-term trends.

Combining asset classes with low or negative
correlations can significantly reduce the
portfolio's overall risk profile. It's one of the few
cases where the whole can be more than
the sum of the parts; a well-constructed portfolio
can have better risk-adjusted returns than its
component parts alone.
The problem is that correlation coefficients shift
over time, so what worked in the past won't
necessarily work in the future. In addition, adding
asset classes to reduce volatility can also drag
down returns, sometimes over multiyear periods.
Moreover, correlations often spike during
periods of market crisis-in other words, exactly
when investors need diversification the most.
While the COVID-19 bear market was swift
and severe, basic portfolio diversification helped
buffer some of the losses. The overall equity
market dropped 34.5% from Feb. 19 through March
23, 2020, but high-quality fixed-income holdings
generally held up well during the flight to
safety. Cash and short-term Treasuries held their
value, while longer-term Treasuries posted
gains. As a result, a basic portfolio mix of 60%
stocks and 40% core bonds would have lost
about 13 percentage points less than an equityonly portfolio during the market downdraft.
In 2020, correlations for many major asset classes
moved higher, but Treasuries were a major
exception. Correlations for cash and short- and
intermediate-term Treasuries remained negative

Taxable Bonds
Taxable bonds encompass high-quality bonds
(U.S. government and government-related bonds,
asset-backed bonds, and high-quality
corporates) as well as higher-yielding credits from
lower-quality issuers (high yield, bank loan,
and emerging markets). These investments provide
varying degrees of effectiveness as diversifiers
with equities.

High-quality bonds, especially Treasury and other
U.S. government bonds, have proved to be the
best diversifiers for equity exposure in a broad
swath of market environments over the past several
decades. The reason is intuitive: Demand for
Treasuries often spikes when investors are seeking
a safe haven. Moreover, interest rates often
decline during such periods, which has provided
another tailwind for government bond prices.
On the flip side, lower-quality bonds have been
much less effective diversifiers for equities,
often losing less than stocks in market downdrafts
but moving more in sympathy with stocks
than with government bonds. That's because the
economic conditions that precipitate stock
market downturns often crimp the outlook
for the indebted issuers of lower-quality credits.
2020 Correlations
The first quarter of 2020 provided a major stress
test for high-quality bonds' reputation as a
portfolio diversifier for equities. As the pandemic
came into view, stocks experienced a short
but extreme sell-off, falling sharply from late
February through late March. While high-quality
bonds certainly held their value better than
stocks, there was a high degree of variation among
fixed-income types.

Morningstar - Q2 2021

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