Some Bonds Are Better Diversifiers Than Others

But not all bonds are created equal. Their diversification potential occupies a spectrum from great to lousy.

Ben Johnson 13.09.2018
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In the context of portfolio construction, the best thing about bonds is that they are not stocks. Their cash flows are generally far more certain, their lives finite, their terms transparent, and their rank in the pecking order of companies’ capital structures higher than common equity. All these attributes lend themselves to bonds being less than perfectly correlated with stocks, making them good diversifiers of equity risk. But not all bonds are created equal. Their diversification potential occupies a spectrum from great to lousy. The best diversifiers are the most boring.

As stocks continue to chug along and interest rates have lifted off from their recent lows and could climb higher still, now is a good time to revisit bonds’ role in a diversified portfolio. Here I will look at the degrees of diversification potential offered by various segments of the bond market. Then I will share a peek at recent trends in exchange-traded fund flows among the largest categories of fixed-income ETFs to assess how investors are positioning themselves to cope with the confluence of full stock market valuations and the possibility of further interest-rate increases.

The Spectrum of Fixed-Income Securities’ Diversification Potential
While bonds share many common features, they are not created equal. Bondholders are lenders, and as such, bonds’ characteristics will vary depending chiefly on the borrower and the length of the loan in question. If your dependable twin-sister/next-door neighbor—let’s call her Trish Bills—asked you to spot her a bit of money for a brief period, you probably wouldn’t hesitate and might not even charge her interest (she’s blood after all). But if you lent money to an out-of-state college buddy with a bad luck streak—let’s call him Hugh Yeeld—you would likely limit the amount you were willing to let him borrow, ask that he return that money sooner rather than later, and require a higher interest rate—all as means of limiting and compensating for the level of risk you would be assuming. Of course, what I’m describing here are the two risk factors that are the primary drivers of returns of fixed-income securities: credit and duration risk. These same factors also drive the varying degrees of diversification potential across fixed-income sectors.

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About Author

Ben Johnson  Ben Johnson, CFA is the Director of Passive Fund Research with Morningstar.

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