Shifting from bonds vs equities to bond and equities
The differences between bonds and equities traditionally mean both have a place in a balanced, diverse portfolio. Recent market events have challenged that pattern but, in the longer-term, the case for holding both bonds and equities remains strong.
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Like strawberries and cream, bonds and equities can go together beautifully. They have long been considered the bedrock of a diversified portfolio, with equities providing growth and bonds providing stability. However, like strawberries and cream left out in the sun too long, this relationship has gone awry in recent years. Why has this relationship worked well historically? And might it do so again in future?
Investing in bonds and stocks is a key source of diversification
Bonds and equities are the foundation of most balanced portfolios. The blend will tend to vary based on risk appetite: lower risk investors will have more bonds and higher risk investors will have more stock market investments, but the premise is the same: bonds support a portfolio during economic weakness while stock markets provide long-term growth.
There are sound mathematical reasons for these assumptions. The differences between bonds and equities mean they can work well together to help form a balanced portfolio. Bonds usually have fixed income streams and therefore do well when inflation and interest rates are falling. This usually happens at a time of weaker economic growth. Stock market investment, on the other hand, favours a climate of better economic growth, when there is more money in the economy and there is more demand for companies’ goods and services, so it is easier to grow their profits.
This diversity matters. Modern Portfolio Theory, a mathematical framework devised by Nobel prize winner Harry Markowitz, suggests that by blending different assets, a portfolio can offer a better risk-return profile than the sum of its parts. This is the theory on which many portfolios are built.
Well established patterns between bonds and equities can sometimes break down
This has been particularly evident since the global financial crisis when central banks brought in unusual measures to prevent a market disintegration. As interest rates dropped, bond markets flourished, particularly long-dated low-risk bonds, such as those issued by developed market governments.
At the same time, stock markets bounced. Lower interest rates created a stronger environment for companies to grow, with borrowing cheap and liquidity abundant. Those companies with a long runway of high growth performed particularly well. For investors, this was seen in the astonishing performance of technology-led companies such as Apple, Amazon, Alphabet, or Netflix.
For more than a decade, this was great news for investors. It didn’t matter whether they directed their capital towards bonds or towards equities, their investments grew. However, it meant that the diversification advantages of holding bonds and equities broke down. Investors were no longer protected by holding both.
The MSCI World Index (USD) dropped over 13% between the start of the year and the end of July 2022, but bonds provided no protection – the average UK gilt fund fell by nearly 12% over the same period.
Many investors have turned to alternative assets to provide the protection they once received from their bond portfolios. This includes areas such as infrastructure, which replicates some of the predictable cash flows of fixed income, but with some inflation protection. Logistics, in particular, has been popular because it’s geared into the growth of ecommerce. People have also looked to alternative parts of the bond market – index-linked bonds, floating rate notes or emerging market debt, for example.
What’s next: bonds vs equities or bonds and equities?
Both bond and equity markets are going through a difficult period of adjustment as extraordinary monetary policy is withdrawn. Just as they had risen in unison during the period of loose monetary policy, so they have fallen in unison as prices have adjusted. It’s difficult to predict how long this adjustment will last. A lot depends on the inflation outlook and whether central bankers feel compelled to keep raising rates to tackle rising prices.
However, it’s likely that over the longer-term there will be a return to more normal patterns. Interest rates are expected to rise in the short-term but then eventually settle at around 3%. While central banks may go back to quantitative easing to deal with future emergencies, the recent experience with inflation may have spooked them.
To some extent, loose monetary policy has only been possible because inflation has been benign. Most economists now expect inflation to settle higher as some deflationary forces, such as globalisation, reverse. This gives central banks less room to manoeuvre. As such, a return to the experimental monetary policy of the 2010s looks unlikely.
Against this backdrop, the argument for holding both bonds and equities in a portfolio to achieve diversification appears stronger today than it has done for some time. However, it’s worth incorporating other diversifying assets such as private equity, infrastructure or commodities to help manage risk.
Investors should also look to diversity bond and equity holdings – including a mix of corporate and government bonds across emerging and developed markets, plus a range of equity sectors and regions. A balanced, diverse portfolio should provide the best risk-adjusted return over time.
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