How bonds can reduce investment portfolio volatility

The inclusion of bonds in investment portfolios is a good way to guard against equity risk, writes Stephen Hart.

Of late I have been making the case for including bonds in investment portfolios, primarily to reduce risk and better safeguard portfolios against the volatility (particularly in equities) seen since late 2007/early 2008.

While I have previously touched on the subject of returns it is now time to review the impact of holding fixed income investments on portfolio returns in more detail.

The analysis will demonstrate that the slow but steady accumulation of fixed income returns often outperforms more volatile returns from equities — and significantly outperforms returns from cash.

The analysis compares monthly volatility of fixed income, cash and equity asset classes and looks at accumulation over a 20-year period.

As previous analysis has highlighted, a 50 per cent allocation to fixed income and a 50 per cent allocation to equities can generate a low-risk portfolio.

What is surprising is that such a low-risk portfolio can be shown to outperform equities over a 20-year time span.

In recent articles I have presented examples of how fixed income investments perform in a mixed asset class portfolio and, more specifically, how bonds help to reduce the volatility of a portfolio with a large allocation to equities.

In an effort to draw out data for long-term returns I will examine the following:

• The annual return characteristics of the major asset classes;
• The summary risk and return attributes of the main asset classes;
• Up and down months for equities and fixed income; and
• The cumulative returns of the main asset classes.

Annual returns

Annual returns from the major asset classes give some indication of the risk and return associated with equities and fixed income. Figure 1 shows the volatility of equities relative to fixed income and the volatility of fixed income relative to cash.

While most investors consider fixed income and cash as falling within the same asset class, it is clearly evident from this data that cash has a much lower volatility than fixed income.

Moreover, the case for separating cash from fixed income is supported by the summary attributes of all the investment asset classes.

Summary attributes

Given this initial indication of annual return variation, it is necessary to look at the average return and risk characteristics of the major indices.

As Figure 2 indicates, the risk factors representing cash, fixed income and equities vary significantly. Figure 2 also shows the benefits of mixing fixed income with equities.

For example, a 50/50 per cent mix of equities and fixed income reduces equity volatility (ie, risk) by around 50 per cent — yet it trims the average return from equities by only 0.66 per cent. It also improves the ratio of return to risk.

Put another way, by making a 50 per cent allocation to fixed income, investors can convert a portfolio exposed to more risk than return, to a portfolio which has approximately 30 per cent more return than risk.

Such an approach to risk requires an appreciation of the variability of equity returns.

Up and down months

Another interesting way to look at volatility is to chart the average positive (‘up’) month and the average negative (‘down’) month for both equities and fixed income.

Figure 3 indicates the average ‘down’ month for equities represents around 4.7 times the average ‘down’ month in fixed income.

On the other hand, the average ‘up’ month for equities is around 2.6 times the average ‘up’ month for fixed income. In other words, equity ‘down’ months are significantly more severe than equity ‘up’ months.

Moreover, as expressed in terms of fixed income market volatility, equity market ‘down’ months (at 4.51 times the fixed income ‘down’ months) are roughly double the severity of equity ‘up’ months (at around 2.57 times the fixed income ‘up’ months).

The use of fixed income to diversify returns tends to moderate the average ‘up’ and ‘down’ months of the portfolio. Fixed income also tends to better balance the size of ‘up’ and ‘down’ months.

Once more, the role of fixed income diversification seems clear. While the frequency of ‘up’ and ‘down’ months is not dissimilar for equities and fixed income, the severity of the ‘down’ months is substantially greater for equities than fixed income.

As Figure 4 indicates, the ‘down’ months for equities represent a much larger movement than the movement seen for the ‘up’ months. While ‘down’ months are less frequent, the size of these ‘down’ months tends to impact cumulative returns as we now consider.

Cumulative returns

Still another interesting way of looking at return streams is to look at cumulative returns for the various asset classes.

It can be expected that fixed income will outperform during recession periods and equities will outperform during growth periods.

The comparison between fixed income and equity returns tends to show how fixed income returns accumulate in a much more consistent fashion.

While the positive months for equities deliver a much larger return than the fixed income market, the negative return months are much larger still.

To some extent, these large negative return months interrupt the accumulation of returns for equities.

In other words, fixed income effectively presents the tortoise in the Aesop fable ‘The Hare and the Tortoise’. By accumulating steady returns, fixed income investors often ‘win the race’ against equities.

Conclusion

Equities provide an important source of return, which effectively leverages investors to the growth prospects of an underlying economy.

Apart from other things, when growth perceptions are strong, equities reflect those perceptions and performance is substantial.

When perceptions of growth are low, or negative, the opposite is the case — investors become leveraged to the negativity of investor perception.

Fixed income has a real role to play in reducing portfolio volatility from equities:

• Annual return characteristics indicate that fixed income returns are far less volatile than equity returns.
• The summary risk and return attributes showed that the risk characteristics of equities need to be carefully assessed and an allocation of 50 per cent to fixed income can reduce risk by around half.
• An analysis of the relative size of up and down markets reveals that equity markets have larger monthly up moves in comparison with fixed income markets while the down moves are significantly larger again.
• Cumulative returns indicate that fixed income comprises a valid alternative to equities, especially relative to cash, and that fixed income has a much more consistent cumulative return stream than equities.

Stephen Hart is director of planner services at FIIG Securities.