Why Own Bond Funds?

I am a “bond guy.”  I worked in an insurance company managing investments for 25 years and spent most of my time worrying about bond duration mismatches, credit quality, defaults, and sector exposures.  We had equities, too, but they comprised a small allocation since they didn’t work very well to hedge liability cash flows.  We loved bonds for their cash flow characteristics and lower risk profile.

Bonds, however, have not gotten a lot of “love” in this post-Crisis environment.  Inflation, which most market commentators said was sure to follow the aggressive global central bank easings (but has yet to materialize), would certainly crush the value of all those long duration bond portfolios, as they say.

But, on days like we have seen most of this year, owning bonds have performed exactly as we would hope; as a hedge against equity volatility.  Year-to-date through July 2019, core bonds have exhibited a negative correlation of -0.41 to the S&P 500; a much higher negative correlation than over longer time horizons (10-year correlation to the market is almost 0.0; granted this is an unusual time horizon).

To all my peers buying short term bond ETFs and mutual funds to protect value and running away from credit quality, you have missed a key value of core bonds; as a diversifier of market risk.  There is certainly a place for all the different varieties of bonds funds, and I like most of them, but not to the exclusion of good old “core” bonds with some moderate duration and investment grade credit quality. They are called “core” for a reason, after all!

Yikes! The aggregate core bond ETF from Schwab (SCHZ) is up 7.86% year-to-date while the investment grade corporate ETF from iShares (LQD) is up 14.02%, pretty close to the S&P 500 returns of 16.2%.

Best to own a well-thought-out diversified mix of different bond types to capture the unique characteristics that each of them offer.