Typically, bond prices can rally 2%, 3%, even 5% or more in times of strife. Be it from Coronavirus, a stock market crash, recession worries, or war. Also, typically, bonds have the room to rally. Interest rates typically might hover around 4% to 6%, giving bonds a lot of room before approaching 0%, or even a negative return. However, the last few years have added some challenges to the theory that bonds will dampen stock market volatility.
Low rates pose a challenge
Several European country’s government bonds are now in negative yield territory. What’s more, the US 10 year Treasury yields only 1.13%. This makes it harder for portfolio managers to rely on the traditional idea of using government bonds for income and capital preservation. However, even if bond yields may not be as attractive as they’ve been in years past, they still help reduce portfolio volatility. This is because bond prices still tend to move inversely to stock prices. This provides a nice counter-balance to falling stock prices, which is usually the main culprit of volatility in a portfolio.
In addition to bonds, innovations in finance have led to more choices for investors looking to reduce portfolio volatility. We have mentioned our use of Buffered ETFs in several recent posts. These provide capped upside potential (10-15%) over the next 12 months. In exchange, they give significant downside protection (anywhere from 10% to 15% or more). In addition, using Large coupon bonds instead of small coupon bonds can help reduce portfolio volatility. This is because Large coupon bonds tend to move less in price than similar small coupon bonds, making them less volatile.
There are no magic silver bullets out there that completely eliminate portfolio volatility. However, there are several portfolio management tools that, when used in conjunction with one another, certainly help reduce overall portfolio volatility. All without giving up the upside potential that portfolio managers and clients strive for.
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