Bonds are low volatility assets
Over history, bonds have shown to have lower volatility than equities. There are two indices which are used to describe the Australian equity and bond markets respectively:
- The ASX200 Accumulation Index – annualised volatility over 10 years of 18.2%
- The Bloomberg AusBond 0+ Yr Credit Index – annualised volatility over 10 years of 1.9%
However, what is often forgotten is that bonds and equities typically move in opposite directions – that is to say they are ‘negatively correlated’. The key advantage of this is that when your equities are doing poorly and you need cash, your bonds will tend to have risen in price and can be used as a cash source.
Smooth Portfolio Performance
The net effect of investing in negatively correlated assets is a smoother profile of returns for your portfolio. The large upside is reduced, but importantly, so is the large downside. This is why for many years asset allocators include a portion of both Bonds and Equities in their portfolio. It is often referred to as ‘diversification’.
When exploring concepts, often it is best to take things to extremes by way of example. Whilst it is unrealistic to expect two assets to be perfectly negatively correlated, it provides a salient example. If you have two such assets and weight the investment amount in each asset correctly, you end up with a perfectly smooth investment return as shown in chart 1.
Chart 1: Two Assets and Portfolios vs Time
We know bonds and equities are not perfectly negatively correlated. So a more realistic example of what can be achieved is shown in chart 2.
Chart 2: Two Assets and Portfolios vs Time
Note: The numbers used in both examples are not taken from numbers realised in the markets – they have been created by us for illustrative purposes only.
What we see is that the portfolio is smoother than either of the assets, and performs between them on a total returns basis – which is what we would expect. With portfolios containing more assets, the theory remains the same.
In general, an investor desires to make more return for taking less risk. Some may have heard of the Sharpe Ratio of an asset, which is theorised along these lines. Here, we use a simple ratio to express the number – Return divided by Risk (i.e. volatility). For example, if the expected annual return is 10% and expected annualised volatility is 18.2%, the ratio would be 0.55.
For the three lines in chart 2 the Return/Risk Ratios are:
- Asset 1 – 1.25
- Asset 2 – 0.88
- Portfolio – 2.14
As we can see, the combination of negatively correlated assets produces a higher ratio, which is desirable.
The benefit to portfolios
Empirically speaking, for your Fixed Income allocation to obtain this negative correlation, it needs two things:
In general, this is achievable on ASX through Fixed Rate ETFs or XTBs. A key difference between these two is that XTBs allow you to choose and control your duration whereas a fund requires you to match the duration of the fund – which often tracks an index (we discuss this more here). As Term Deposits cannot be sold nor change in price, they do not provide negative correlation. Term Deposits may enjoy the benefit of protection under the Financial Claims Scheme.
Having a combination of negatively correlated assets in your portfolio may produce a more desirable outcome. Since bonds and equities are generally negatively correlated, having some XTBs in your portfolio may provide better outcomes for you over time – as well as give you an asset you can sell if your equities have lost a lot of value and you don’t want to sell them.
If you want to read further on the topic of bond volatility we discuss one of the key reasons as to why bonds have lower volatility than equities here. We discuss the implications of this lower volatility when buying XTBs here.