Could long-term bonds contribute stability and increased income to your investment portfolio?

New Delhi: In 2022, a significant shift occurred: both global equities and bonds yielded negative returns, breaking a trend that had spanned over half a century. This prompted numerous market experts to question the relevance of the traditional "60/40 portfolio."

Even before 2022, the combination of historically low bond yields and robust equity gains had sowed doubt among investors about the necessity of retaining bonds in their investment mix. Nonetheless, concerns regarding potential market volatility due to a global growth deceleration and rising bond yields following interest rate hikes have spurred a reconsideration of bonds' role in portfolios.

Beyond the immediate market landscape, a broader query emerges: Should long-term bonds consistently maintain a position in investment portfolios throughout the varying cycles of the market?

In 1952, Nobel Laureate Harry Markowitz introduced the concept of the 60/40 portfolio—a combination of 60% equity and 40% bonds—as a strategic long term investment approach. Since then, the 60/40 portfolio model has served as a guiding principle for countless investors aiming to optimize returns while managing risk.

Lending stability to a portfolio

Equities offer the potential for robust returns, yet they also come with the inherent risk of volatility and significant market corrections. In contrast, bonds play a role in stabilizing portfolios, particularly during periods of equity market volatility. Let's delve into some data to gain a deeper understanding of this phenomenon.

A closer look at the data reveals that equities, as represented by the Nifty 50 index, have shown impressive returns, surpassing 75% in select years, but have also experienced declines of over 50%, as was observed in 2008. Over the past two decades, equities have averaged an annual return of 20.8%.

On the other hand, bonds, represented by the Crisil Composite Bond Fund Index, have encountered only four instances of negative returns within the same time frame. Interestingly, the sole decline was a minor 0.33% dip noted in 2004. The historical average annual return for bonds stands at 6.8% over the last two decades. To provide a more precise measure of volatility, let's examine the standard deviation of calendar year returns. For the Nifty, this figure stands at 29.6%, whereas for the Crisil Composite Bond Fund Index, it is 3.7%.

A portfolio adhering to a 60/40 allocation, rebalanced annually, has yielded an average annual return of a commendable 15.2%, coupled with a standard deviation of 17.6%. The maximum loss experienced by this portfolio was 27% in 2008.

Securing returns against market downturns

Even for investors who maintain a long-term perspective and possess the capability to withstand short-term market fluctuations, setting aside a portion of their portfolio for bonds can offer advantages. Typically, following a substantial market correction, equities frequently witness strong recoveries. Nonetheless, in an unfortunate scenario where the requirement for funds aligns with a market downturn, investors might face the undesirable necessity of selling equities during an unfavorable period. In such situations, bonds can emerge as a valuable safeguard.

A steady income stream

Aside from contributing to portfolio stability, bonds also yield a steady and reliable income stream. The fixed payments originating from bonds offer investors a consistent source of earnings over the investment duration. This anticipated income can instill a feeling of financial reassurance, particularly resonating with retirees and individuals aiming to meet living costs or attain various financial goals.

Short-term versus long-term bonds

Now, let's delve into the contrast between short-term and long-term bonds. Generally, bonds that reach maturity within 3-4 years are classified as short-term, whereas those with maturity periods surpassing 7 years are categorized as long-term. Due to the extended duration of lending, longer-term bonds provide more substantial yields and returns, but they are also more sensitive to shifts in interest rates. When rates drop, the value of long-term bonds can increase, possibly resulting in capital gains. Conversely, rising rates can diminish their value. The fluctuations in value—both gains and losses—are more pronounced for long-term bonds compared to their short-term counterparts.

In context of current market

In the past year or so, the majority of global central banks have responded to heightened inflation by implementing interest rate hikes. As a result, bond yields have experienced a significant upsurge. This trend has also been observed in India, where the RBI has introduced a 2.5% increase in policy rates since May 2022.

Consequently, the yield on India's 10-year government bonds has risen to around 7.2%, in contrast to the sub-6% levels recorded in 2020. It seems that both the US Federal Reserve and the RBI might not pursue further rate hikes, suggesting that bond yields might have reached their zenith. Furthermore, the delayed effects of these rate hikes on global economic growth are still yet to fully manifest.

The potential deceleration in global economic growth introduces the possibility of heightened volatility in global equities. Given this current backdrop marked by enticing bond yields and expectations of impending market turbulence, bonds could serve as a potential stabilizing factor for portfolios. Additionally, as we anticipate the eventual implementation of rate cuts, we might witness some capital appreciation in long-term bonds, although this development could still be a few months away.

Relying on bonds’ performance

While we have utilized the 60/40 portfolio as a point of reference, the exact distribution towards bonds is contingent upon several variables, encompassing risk-return projections, liquidity needs, investment horizon, tax implications, and unique constraints. Nevertheless, integrating bonds into investor portfolios remains pertinent, regardless of shifts in market cycles. Investors might consider modifying their bond allocations to align with the prevailing market landscape.