Do Bonds Still Provide Diversification?

Some market observers have made the assertion that we are at the tail end of a 35 year bull market and that therefore, rising interest rates will reduce the attractiveness of bonds for investors. Another school of thought is that the winding down of quantitative easing (QE) will trigger a fall in bond markets in concert with falling equity markets.

Asset allocation will surely suffer if bonds can't be relied upon as they have in the recent past.  

What impact could rising yields have on bond prices?

Take the UK Government bond for example. It currently yields 1.44%. If the bond's yield rises by 1%, the price of the bond itself should fall by 8%. Remember however that bonds pay a regular coupon payment, which could themselves be reinvested for higher returns. If the 1% price rise increase occurred over the course of a year the loss would be closer to 6.5%.

In addition, investors will suffer losses if interest rates rise, but these could be offset by the equity component of their portfolios as rising rates are generally held to be indicative of a healthy economy, with the expected knock on effect of growth in the share market.

Are bonds losing their portfolio diversification benefits?

A loss of diversification in portfolios is a serious issue. Holding investments that are negatively correlated in your portfolio is extremely beneficial as when investment A falls, the fall is counteracted by investment B that is negatively correlated with it. This is the role that bonds have filled in concert with equities for the last 30 years.

Some have argued that the end of QE will result in yields for bonds rising, and the value of equities and bonds falling at the same time.

But will this actually happen? The introduction of QE in December 2008 shows a small level of positive correlation between UK Gilts and Global Equities, with the trend accelerating in the last 2 years.

However, without further evidence, it's difficult to predict what will occur, as it can't be definitively proved that the correlation effect has been lost.

UK gilts have had a correlation of 0.13 to global equities, which is much lower than UK equities, which have a correlation of 0.79 to global equities.

For the time being, bonds are still the best diversification tool when paired with equities in a portfolio.

Westminster Wealth Management can assist in helping you to navigate your financial future, and expert advice is valuable in complicated times just as much as in simple ones. Contact us today.

The value of investments and income from them may go down as well as up and you may not get back the original amount invested.

Information is based on our current understanding of taxation legislation and regulations which is subject to change.

Past performance is not a reliable indicator of future performance.