I own BND in an attempt to hedge my portfolio against my stock ETF declines, based off of the Bogleheads philosophy. I've noticed that with this ETF, over the relative long term, I've made but modest gains (compared to stock ETFs) during "good times", and still lost along with the stock ETFs during "bad times" (see the linked chart).
Is the advice I've followed antiquated? Is there any point in holding a bond ETF or mutual fund these days?
I read an article about this very issue in January 2023, and I saved the graphic that illustrates the historical relationship between the S&P 500 as an indicator for equities and the 10-year U.S. Treasury bond as an indicator for bonds. Source: Deutsche Bank
As the scatter graph clearly shows, the most common outcome in a given year falls in the upper right quadrant, where both equities and bonds post gains.
The next most common outcome is the lower right quadrant where equities lose but bonds gain. There's your "hedge".
The third most common outcome is the upper left quadrant where equities gain but bonds lose. Not so bad because the percentage gain in equities typically exceeds the loss in bonds.
The least common outcome, the one that you experienced, is where both equities and bonds lose for the year. And the year 2022 was, as you see, a complete outlier in this 150-year time span.
If you play the percentages based on history, your "hedge" philosophy is not bad as it reduces risk. But occasionally you get burned, as in 2022.
For perfectly hedged investments the investments would be perfectly anti-correlated, i.e. if the value of investment A goes down, the value of investment B goes up an equivalent amount, and visa versa. The purpose of a hedge is not to maximize gain, but to avoid risk, i.e. lock in a certain return.
There is a casual common wisdom that stock returns and bond returns are somewhat anti-correlated: bonds have to be cheaper when the stock market is doing well and visa versa. This is roughly true much of the time, but there seem to be periods when the stock market and bond market are correlated rather than anti-correlated, that is bonds and stock can both be down or up at the same time. If that's the case owning bonds won't act as a hedge against stock market declines. Folks argue that has exactly been the case for the last few years.
Is it true? Will it continue to be true? Shrug. You pay your money and you takes your chances.
The concept of using bonds as a hedge against stock market declines is based on observations during periods where interest rates are relatively stable. A common theory is that when the market turns against stocks, the money from that sell off will be used to buy bonds, increasing the demand for bonds. In addition, it's often the case that market downturns come during periods of low growth and therefore lower interest rates. Lower interest rates on new bonds issuances increase the value of older issuances of bonds that pay higher interest rates.
Recent events, however, do not fit into that model. The extremely low interest rates for debt that were in place since the great recession resulted in a lot of money going into the stock market and increasing valuations. Bonds were unappealing due to the very low rate of return.
When the fed increased rates drastically it took some of the wind out of the sails of the stock market. It also crushed the value of existing bonds. The former should be fairly intuitive: less 'cheap' money for people to put into stocks. The latter is simply related to the fact that new bonds are being issued at higher rates so the existing bonds price must fall in order to produce an equivalent yield. That is, loosely, if you have a bond that yields 1% and a new bond with equivalent risk pays 5%, no one will pay you face value for that 1% bond. It will be discounted to the point that it yields 5%.
Will the historical relationship between the stock market and the bond market revert back to the previous trend? That's a matter of much speculation. It might if interest rates (and inflation) stabilize. There are also a lot more types of investments than in the past, so the expected flow of money from stocks into bonds when the market is down may not be as clear-cut in the future. For example, the private credit market which is an alternative to publicly traded corporate bonds has grown immensely.
The above is a story based on theory and interpretations of data. As with any investment theory, you should be careful about believing a story too much. In particular, try to understand the assumptions that investment theories are based on so that you can reevaluate if those assumptions do not hold.
Is the advice I've followed antiquated? Is there any point in holding a bond ETF or mutual fund these days?
Find or create a long term chart of your two securities and eyeball the correlation or lack thereof.
You can also use a Comparative Relative Strength indicator to visualize this relationship. Fidelity offers this explanation.
