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Posted by on Apr 2, 2014 in Sage Advisory Services

Not All Bonds Diversify Stock Portfolios

By: Sage Advisory Services, Portfolio Manager of the AdvisorShares Sage Core Reserves ETF (HOLD)

We talk to a lot of investors who own bonds to offset the risk of their equity holdings. However, just because an investment claims “fixed income” status, that doesn’t mean it provides much diversification versus equities. Case in point: high yield bonds.

High yield corporate debt generates returns that are highly correlated to the returns of stocks, and it is for that reason that we regard them as a kind of “equity light” or “decaf equity.”Although their returns are not usually as volatile as stock returns, they tend to move directionally the same. So, for those investors who hold high yield hoping that they will be protected during a bear market, think again. When stocks correct, high yield debt tends to follow.

Additionally, over shorter intervals such as rolling 3-month and 6-month periods, their correlations periodically spike up to surprisingly high levels. Remember 2000 and 2008?

By contrast, high quality bonds such as investment-grade corporates and Treasuries tend to buffer portfolio volatility to a much greater degree. Over various time periods, their correlations relative to stocks range from significantly negative to moderately positive.

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The explanation is intuitive, and it has to do with the timeless human emotions of fear and greed. When investors are feeling confident and bullish, they shovel money into investments that generate significant returns. This includes stocks and, if they own fixed income, it often includes high yield bonds, bank loans and/or emerging market debt. Conversely, when their risk outlook changes, and they become fearful, they pull money from speculative areas of the market in favor of “flight to quality” investments such as cash and high quality fixed income.

All that is as it should be, so long as investors understand the role that high yield bonds play on their team. Sure they can generate high amounts of income, and if the markets stay range-bound for prolonged periods of time, investors can clip high coupons for months and months. But when markets correct, they tend to do so quickly.

Think of it this way: When do investors need diversification? Do they need it during bull markets? Absolutely not. In fact, when stocks are rallying they would do better to concentrate their holdings in high-octane, high-beta assets.

The time investors really need diversification is when the markets turn, and they are looking for uncorrelated assets to buffer portfolio volatility. Well, guess what – high yield bonds will probably not do that job very well. Same goes for floating rate bank loans, by the way.

OK, now that we got all the ominous warnings out of the way, here’s the ironic punch line. Investors can probably avoid all the pitfalls we have discussed if they just maintain discipline and refrain from making knee-jerk decisions when they suffer short-term losses.

Sure, the stock market can correct sharply and high yield bonds can follow along, causing deep, painful portfolio losses for a number of months. If they choose to sell their high yield bonds after the correction, they lock in their losses. For instance, selling high yield bonds at the end of 2008 would have resulted in a loss of -26.2% over the prior 12-month holding period.

However, if they had chosen to hang on to those investments, they would have realized significant profits in their high yield bonds by year three.

In most cases over the long term, nearly all total returns generated by diversified bond portfolios come from their income. Bonds are issued at par and mature at par. So long as defaults are not significant, cumulative returns are a function of the amount of income distributed and the investor’s hold time.

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How does investor discipline factor into the equation? If investors have the discipline to avoid the temptation of bonds that could produce short-term losses greater than they can handle, or be willing to continue holding bonds that have delivered painful short-term losses , they can generate solid returns regardless of fluctuations in the broader markets.