Can bonds keep beating stocks?

Diversification, goes an adage attributed to the late Harry Markowitz, is the only free lunch in investing. The idea later helped him win a Nobel prize for economics. Markowitz’s genius was to realise that a portfolio spread across lots of assets could have the same potential for returns as a more concentrated one, but with less scope for losses. In other words, diversification allows investors to take less risk without sacrificing reward—quite some freebie.

So much for theory. In practice, diversification is all too often a drag. Most investors know that, over the long run, stocks are their best shot at high returns. Reducing risk by diversifying sounds good, but doing so without giving up profits would require other assets with similarly stellar prospects. In fact, the main alternative to shares is bonds, which tend to yield much less. To a true Markowitzian, the hit to returns is worth it if it brings down risk by even more; for get-rich-or-die-trying types, such logic cuts no ice. Yet the latter group might be more receptive to the virtues of diversification just now. Over the past couple of months, even as stock prices have swung madly and retreated from all-time highs, bondholders have been racking up gains.

Suppose you started 2023 by investing equal amounts in two exchange-traded funds: “QQQ”, the largest vehicle tracking America’s tech-heavy Nasdaq 100 share index; and “TLT”, its equivalent for Treasury bonds. After 18 months, your tech stocks would have been worth more than twice as much as your Treasuries. Compared with an all-stock portfolio, your bond position would have cost you half your potential returns.

Now, though, things have changed. Since the Nasdaq’s peak in mid-July the index has declined by 7%, while the value of the TLT fund’s Treasuries is up by 9%. Look at American shares more broadly (or, indeed, at their international peers), include corporate debt alongside the sovereign sort, and similar patterns hold. The question now is whether bonds can keep up their rare winning streak.

Should share prices start plunging once more, the answer will be “yes”. During a crash, bonds are less vulnerable than stocks: in extremis, after all, it is a firm’s creditors rather than its shareholders who have the first claim over assets. Rich countries’ government debt, meanwhile, carries virtually no risk at all of default. Moreover, troubled times can be a boon for bonds. If stockmarkets are in trouble because investors fear slowing growth, as happened over the summer, then they are likely to mark up the probability that central banks will cut interest rates. That sends bond yields down and prices, which move inversely to yields, up. Amid a general panic over stocks’ valuations—as, again, occurred in August—the safe-haven appeal of sovereign debt, and American Treasuries in particular, tends to rise.

However, investors should bear a couple of things in mind before stocking up on debt. One is the amount of good news that is already baked into prices. Following bonds’ summer rally, the interest-rate market now expects the Federal Reserve to reduce its policy rate unusually quickly. Traders have priced in a full percentage point of cuts before the end of this year, followed by another 1.5 over the course of 2025. In the past, such rapid loosening has normally been associated with recessions or financial crises, neither of which most investors expect today. Should the Fed prove disappointingly hawkish, as it often has in recent years, there is plenty of scope for yields to rise and bond prices to fall.

The other thing that should give would-be lenders pause for thought is that borrowers have been rushing into the market. During the first week of September, for example, American investment-grade companies issued more than $80bn-worth of debt. That is more than in any other week since May 2020, just after activity resumed following the onset of the covid-19 pandemic, and when interest rates were close to zero. Emerging-market firms have been on a borrowing spree, too. The fact that borrowers are now in a hurry to sell their bonds suggests they think waiting to do so would result in them paying higher rates. If they are right, the lenders now buying the debt will soon regret it.

It goes without saying that none of this is an argument against diversification. Bonds belong in investors’ portfolios not because they regularly post superior returns, but because they sometimes do well when stocks fare terribly. So bondholders should enjoy their spell in the sun—even if they should not expect it to last all that long. ■