Bonds: The Battery Back-Up For Your Portfolio
Over the summer we installed a battery back-up for the sump pump in our basement. After the installation, our area proceeded to go into a drought, not recording a meaningful rainfall for more than 6 weeks. Still, that money was the best money I’ve spent in years. Why? Not because I needed it, but because of the peace of mind it gave me, should I need it. Even though I already had a sump pump that had worked great for six years, we’ve been lucky that our power hasn’t gone out when it was running. Though, that thought crossed my mind every time I heard it working to pump out excess water from around our foundation during heavy rainfalls.
You may be wondering how this relates to investing. Well, having some fixed income or bond exposure in a portfolio can serve as your portfolio’s battery back-up! The U.S. equity market has been functioning great for a long period of time (minus a moderate pull back in 2022). In fact, it’s been on such a strong run for over a decade that we may have forgotten about the need for a back-up. The amount of fixed income in a portfolio, along with the portfolio duration, should vary depending on an investor’s risk tolerance and investment objectives. But, in times of volatility you’ll be glad you had some exposure as fixed income can serve as a volatility buffer and provide some much-needed rebalancing power.
Let’s look at some of the biggest equity drawdowns in history and see how bonds performed during the same time period. The chart below from Northern Trust shows six major drawdown events in reverse chronological order. According to Northern Trust, the average equity drawdown across these six events was -49.2% while the average bond return during these six events was +12.0%.
Data Credit: Northern Trust
Fixed income tends to serve as a buffer for volatility for a number of reasons. For one, weak stock performance is often accompanied by poor economic performance (i.e., a rise in unemployment). These impacts often lead to interest rate reductions by the Federal Reserve Bank which, in turn, tends to increase bond prices. Volatility and uncertainty can also lead to a “flight to quality” (i.e., a time where the safety of short-term U.S. treasury bonds make them the most popular investment in the world).
History has shown that investing in the stock market has proven to be profitable over the long run but brings substantial volatility as well. Having some bond exposure in a portfolio can help to lower portfolio volatility and provide “dry powder” for rebalancing (i.e., preserve capital for adding to equity investments following drawdowns). While bonds are expected to underperform equities over the long run, they serve a critical function in portfolios. That is, just like a battery back-up to a sump pump, they stand ready to assist when you need them most.
Sam Harris
Founder | Private Wealth Advisor | Fiduciary
Patina Wealth
