Investors have used fixed-income assets and bond exchange traded funds to help cushion the shocks in the riskier equities market. However, as we look to a longer time horizon, the diversification effects of bonds begin to diminish.
Bonds may be offering lower long-term protection from stocks than what many have come to believe, writes Mark Hulbert for Barron’s.
Since 1970, the correlation coefficient between annual returns of the S&P 500 index and long-term Treasuries was 0.02- a 1.0 reading would indicate perfect correlation and a zero means no correlation. However, looking at five-year returns, the correlation coefficient rises to 0.36, and over 10-year periods, the coefficient rises to 0.67.
Between January 1966 and November 1982, the Dow Jones Industrial Average remained flat in nominal terms, but in inflation-adjusted terms, the Dow lost more than two-thirds of its purchasing power. Meanwhile, bonds were pummeled as long-term rates jumped to almost 15% from below 5%.
Nevertheless, investors should still hold some bond allocations to help level off volatility in the equities market but look toward cash and short-term bonds instead, according to James Stack, editor of the InvesTech Research.
While the yields may be less than ideal, the short-term debt and cash will help cushion the blow during a market decline.
For instance, Stack points to the Vanguard Short-Term Investment Grade bond fund. Investors can also take a look at the ETF version of the fund, the Vanguard Short-Term Bond ETF (NYSEArca: BSV). BSV has an average duration of 2.7 years and a 0.79% 30-day SEC yield.