Globe and Mail columnists Rob Carrick.The Globe and Mail
Entrenched low interest rates are causing a misguided re-think of bonds.
The analysis goes like this: With yields as low as they are on government and blue-chip corporate bonds, there's no point in holding them. The five-year Government of Canada bond now yields about 0.7 per cent, which compares to a recent inflation rate of 1.7 per cent. A 30-year bond gets you just barely ahead of inflation with a yield of 1.9 per cent.
Frustration with these yields is understandable, but it misses the point. As ETF and index fund giant Vanguard said recently in a blog for institutional investors, bonds have never been more valuable than they are today by one key measure. The measure is correlation to the stock market. According to Vanguard, price changes in 10-year U.S. Treasury bonds over the past five years have shown the lowest correlation to stocks in history. The average correlation since 1871 is zero. Over the past five years, the correlation to the S&P 500 is minus 0.6 per cent.
One of the biggest challenges these days in portfolio-building is correlation, or the tendency of markets to more or less move up and down in the same cycles. With government bonds, you finally have the long-sought asset that moves independently of stocks. Can this last? Vanguard says stock-bond correlations in the United States tend to fall when investors are worried about slow growth and the possibility of deflation. That's more or less the world we live in right now.
Vanguard's ultimate message is important – stop looking at bonds for returns and start considering them as a diversifier. It's tough to do because the benchmark FTSE TSX Canada Universe Bond index has delivered very satisfactory annualized total return of 5.4 per cent over the past 10 years. Those gains were fuelled in large part by falling interest rates. Rates could fall further – remember, we have negative rates in parts of Europe and Japan. But the more likely outcome is stable rates that creep higher when the economic outlook improves. All of this suggests that for now, the return on bonds amounts to the puny yields that are so frustrating to investors.
Get past it. The reason you're holding bonds is because they're not going to follow the stock market down in the next correction.