FREE NEWSLETTER
ABOUT ONCE A WEEK, someone will say to me, “I don’t understand bonds.” Sometimes, they’ll state it in stronger terms: “I don’t like bonds.”
Fundamentally, bonds are just IOUs. If you buy a $1,000 Treasury bond, you’re simply lending the government $1,000. The Treasury will then pay you interest twice a year and return your $1,000 when the bond matures. That part is straightforward. What’s more of a mystery is why we should own bonds and what we should expect from them.
In a recent article, investment researcher Ben Carlson highlighted why this is such a mystery. Carlson argued that the way investors tend to think about bonds doesn’t match the data. Specifically, bonds have a reputation for moving inversely with stocks. When stocks go down, bonds tend to go up.
This is known as a negative correlation, and it’s the reason stocks and bonds tend to work so well together. In 10 out of the past 50 years, the stock market has lost value on an annual basis. In nine of those 10 years, bonds gained value. That’s been a tremendous benefit.
Investors sometimes refer to this as a “flight to safety.” When the stock market drops, investors turn to the security of bonds, and that pushes bond prices up. We saw this as recently as a month ago. As you may recall, in early August, the stock market dropped briefly, in response to a weak unemployment report and other factors.
In total, the stock market dropped 6% in three days. And in those three days, bonds rose, gaining almost 1.5%. It was a perfect example of portfolio diversification. For many investors, this is reason enough to own bonds. In fact, I often describe bonds as being like insurance. They’re there to carry investors through periods when the stock market is down.
But Carlson, the researcher, argues that we aren’t giving bonds enough credit. Seeing bonds only as insurance ignores their performance the rest of the time. The fact is, bonds have delivered generally steady and positive returns through most market environments—not just during periods when the stock market has been down.
Bonds, in fact, have delivered positive performance in 44 of the past 50 years. While those returns have been lower than the returns on stocks, they’re not immaterial. On average, between 1974 and 2023, bonds returned 6.3% a year. Bonds, in other words, aren’t just insurance.
You might wonder how this is possible. If bonds are inversely correlated with stocks—rising when stocks fall—then doesn’t that mean that bonds should fall when stocks rise? This is where bonds’ reputation is a bit misleading. What the data show is that stocks and bonds are only sometimes negatively correlated. More often, the correlation hovers around zero, meaning there’s no strict pattern to how stocks and bonds trade relative to each other.
Recent data illustrates this. According to J.P. Morgan, over the 10 years through June 30, the correlation between stocks and bonds has been slightly positive, at 0.32. But over the 10 years ending June 30, 2021, the correlation was slightly negative, at -0.21. In other words, bonds and stocks generally exhibit no consistent correlation—except in times of crisis. That’s when the correlation does fairly reliably turn negative. During the early part of the pandemic in 2020, for example, short-term bonds rose when the stock market fell. This dynamic makes bonds an excellent tool for diversification.
Another lesson from the data: It’s important to be aware of the risk posed by recency bias—that is, the tendency to extrapolate from recent experience. Over the past few years, many investors have soured on bonds, but it’s important to recognize that this has been an unusual period. Why? When the Fed dropped interest rates in 2020 in response to COVID, yields on bonds and cash both dropped in tandem. For a time, both were near 0%.
That made bonds and cash seem interchangeable—and equally unappealing. Then, when the Fed began raising interest rates in 2022, yields on many savings accounts quickly rose to the 4% to 5% range. Meanwhile, bonds lost value, with the most popular bond index down more than 10% in 2022.
Result? For the past few years, cash has looked like a better bet than bonds. But this has been an unusual period, and there’s no reason to expect it to continue. In most years, bonds have delivered considerably higher returns than bank savings accounts. Indeed, with the Federal Reserve now signaling that it’s ready to begin lowering rates, this is a good time to review your holdings.
If you’ve been stockpiling cash, benefiting from today’s high rates, you might consider moving some of that over to the bond side. Not only will that position you to capture the bond market’s generally higher returns relative to cash, but it’ll also position you to benefit from the price appreciation that typically lifts bonds when interest rates fall.
Even though the Fed hasn’t formally lowered rates, market rates are already starting to adjust. Since 2022, short-term interest rates have been higher than long-term rates—a situation known as an inverted yield curve—but just this past week that reversed. This is a sign that we may be entering a more normal period, where bonds will deliver better returns than cash.
As you review your bond holdings, what else should you consider? In the discussion so far, I’ve been referring to the bond market in general terms. But some bonds are much more highly correlated with stocks—and thus offer less of a diversification benefit—than others. Corporate bonds, and especially high-yield corporate bonds, tend to exhibit strong positive correlation with the stock market, making them less useful as a diversifier than Treasury and municipal bonds.
Another way in which bonds differ from one another is in their maturities. Intermediate-term bonds will tend to lose more in value than short-term bonds when interest rates rise and to gain more in value when rates fall. Today, with rates starting to fall, intermediate-term bonds have more to gain. But to guard against future interest rate changes—which could go in either direction—I’d hold a mix of both short- and intermediate-term bonds. What about long term bonds? In my view, they carry far too much risk and typically shouldn’t be part of a portfolio.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
Want to receive our weekly newsletter? Sign up now. How about our daily alert about the site's latest posts? Join the list.
This article is excellent, but I have to admit I am not following it. The stock market has been so good in recent years that even with a few big down years, the cumulative returns dwarf bond returns (and offer the only way to outrun inflation, too.)
I do diversify in a few bond funds (and my pensions and Social Security also operate like bonds), but I figure I’lll stay way overinvested in stocks for a while more – I’ve been playing with house money now for a long time, and only a big drop (like from a war or other catastrophe) will bring me back to the returns I would have had from a classic stock-bond allocation.
EXACTLY ! I am in a similar situation of pensions and SS covering all of our expenses acting as bonds. After so many decades of being fully in the market with stock indexes and all of the gains it’s produced over those years I don’t feel the need to have bond funds in my portfolio. I view bonds as something that only keep you equal to inflation usually.
If I would have had bonds all of these years I would only have half of what I do today
Good article.
But I have to say I haven’t put a penny into any bond that was a TIPS.
uh … was NOT a TIPS.
I’m so old I could use an edit button.
What about using IBIK iShares iBonds TIPS etfs?
You can get it by clicking on the little gear icon next to your post 😄
I am trying to understand Bond ETF’s, for example Vanguard’s BND. Can someone help me understand?
Adam, good article. How about a word on a bond fund’s sensitivity to Fed’s fund rate changes? This can be estimated based on the bond fund’s duration, a concept that may be confusing to some.