2018 has been a trying year for bond investors. As of this writing, the Bloomberg Barclays Aggregate Bond Index is on track for the second worst year in its entire history (since 1976), down -2.49% year to date. Since 1976, the index has had a negative total return only three times in 41 calendar years — the worst being -2.9% in 1994. To put that into perspective, the worst year for the S&P 500 Index since 1976 was a total return of -37.0% in 2008.

It is always helpful to remind ourselves why we own bonds and the purpose they serve in a portfolio. High-quality bonds are a great diversifier of the risks of owning stocks. In the short term, bonds and stocks can fall together. However, over longer periods, they rarely fall in unison. In fact, the 10-Year U.S. Treasury and the S&P 500 have fallen only 3 times in the same calendar year since 1928. The chart below shows each calendar year the S&P 500 was down since 1926 (blue) and what the return was in intermediate (grey) and long-term (orange) U.S. Treasury bonds. Bonds provide uncorrelated returns to stocks when you need them most – in equity market downturns.

For all the talk of the impending bear market in bonds — which has been the talk for 5-to-7 years now — it is helpful to put bond bear markets into perspective. The magnitude of bond bear markets is not near the extent of stock bear markets. Also listed below are the average and worst calendar-year total returns for a variety of assets:

As observed, since 1976, the average total return for down calendar years in various bond asset classes ranged from -2.03% to -6.04%. This is far less when compared to the average total return for stocks during down calendar years, -11.05% to -13.61%. As a reminder, the good news is that those negative years do not normally coincide in the same calendar-year. For those three years when they did, bonds still helped to cushion the blow from significant stock drawdowns, as the bond losses were significantly less than for stocks. See:

Stocks and bonds generally do not stay coupled for long as they behave differently in varying parts of the economic cycle. Even in the worst period for bonds from 1940 to 1980, when the yields on government bonds rose from 2% to 13%, stocks and bonds were only down two times in the same calendar year.

Concerning the markets and the economy, to paraphrase the words of the great investor Howard Marks, “We may not know where we are going, but we’d better have a good idea of where we are.”  We are 10 years into one of the longest bull markets of the last 90 years and 10 years into one of the longest economic expansions of the last 90 years.

Unlike the laws of physics, where if one drops a rock it falls to the ground every time, there is no law that states bull markets or economic expansions end at 10 years. However, they historically never have lasted much longer. While we cannot predict, and we do not at this moment foresee the end of this economic expansion, we can prepare for the inevitable downturn when it comes. Taking all of this into consideration, we believe we are in a period where it will not benefit to be too aggressive or too defensive. Rather, we are in a time when there is reason to act with prudence and keep in mind the primary reason an investor owns bonds — which is to provide uncorrelated returns when you need them the most.

 

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