When we talk about asset allocation, we refer to the distribution of funds across different types of assets, which have different risk and return. For example, stocks have high expected returns but also high risk, while government bonds are a low-risk asset with relatively low expected returns. In addition to stocks and bonds, commonly traded assets include gold, commodity futures, and real estate investment trusts (REITs). Here, we will analyze the advantages and disadvantages of various bond investments.
Common Targets
The most simplified asset allocation strategy typically involves investing in both the stock market and the bond market. When choosing a passive index-tracking bond ETF, the following options are usually popular:
- US total bond market ETFs, such as BND and AGG.
- Mid-term US treasuries ETFs, such as VGIT and IEI.
- Long-term US treasuries ETFs, such as VGLT and TLT.
- Global investment-grade bond excluding US ETFs, such as BNDX.
- Global investment-grade government bond excluding US ETFs, such as BWX.
Generally, if investing in a global bond market excluding US ETF (BNDX, BWX), investors will also pair it with a US bond market ETF to achieve a complete global bond market allocation.
Looking at the types of index-tracking, there are two main options. One is to include investment-grade corporate bonds (such as BND and BNDX), while the other is to only invest in investment-grade government bonds (VGIT, VGLT, BWX). The other option is to only invest in the US bond market (BND, VGIT, VGLT) or to invest in the global bond market (BNDX, BWX).
Whether include Investment-grade Corporate Bonds
Stocks are expected to have higher returns than bonds, so what is the reason for combining stocks and bonds? The reason is to avoid selling stocks at a time when they happen to be experiencing a downturn. By pairing stocks with assets whose trends are negatively correlated with those of stocks, the overall loss of assets can be reduced, or even result in positive returns (depending on the ratio of stocks and bonds). Here, we will use Vanguard Total World Stock ETF (VT) to represent stocks and calculate the correlation coefficient using Portfolio Visualizer from February 2010.
| VT vs BND | VT vs VGIT | VT vs VGLT | VT vs BWX | |
|---|---|---|---|---|
| Correlation Coefficient | -0.04 | -0.39 | -0.48 | 0.50 |
It can be seen that BND is uncorrelated with VT, while VGIT and VGLT have a good negative correlation. It can be understood that BND includes investment-grade corporate bonds, so when the stock market performs poorly, people lose confidence in companies and fear default, which causes both investment-grade corporate bonds and stocks to decline, thus making them positively correlated. Therefore, only when US Treasuries are combined with investment-grade corporate bonds, they will be uncorrelated.
You can also look at the global stock market crash caused by the pneumonia epidemic earlier this year, with the monthly returns of VOO, BND, and VGIT, among which VOO is the Vanguard ETF that tracks the S&P 500 index.
| Time | VOO | BND | VGIT | VGLT | BWX |
|---|---|---|---|---|---|
| 2020/01 | -0.04% | 1.98% | 2.22% | 7.29% | 0.42% |
| 2020/02 | -8.10% | 1.67% | 2.08% | 6.60% | 0.02% |
| 2020/03 | -12.46% | -1.43% | 2.94% | 6.42% | -3.76% |
| 2020/04 | 12.79% | 2.76% | -0.02% | 0.97% | 1.47% |
It can be seen that only US treasuries have a hedging effect, and even BND’s investment-grade corporate bonds still decline during stock market crashes. High-yield bonds with a lot of cash flow, also known as junk bonds, will inevitably suffer even greater declines.
US Bond Market vs Global Bond Market
As shown in the table above, the correlation coefficient between BWX and VT is as high as 0.5, and the trend at the beginning of the year is similar to that of the stock market, except that the decline is relatively small. When a crisis occurs, the US government is the most trusted, and the default probability of investment-grade government bonds relative to US government bonds is high, so BWX falls with the stock market. Of course, if all bonds are US treasuries, they will be wiped out if the US government collapses, so whether to allocate non-US government bonds is up to personal discretion.
Mid-Term and Long-Term US Treasuries
As shown above, compared with mid-term US treasuries, long-term US treasuries have a higher negative correlation with the stock market and a higher return rate during the epidemic period. If we look at the annualized return rate from February 2010 to July 2020, VGIT is 3.47% and VGLT is 8.85%. Clearly, VGLT is better in terms of returns. Then why choose VGIT? The advantage of VGIT is that its volatility is smaller. The standard deviation of VGIT is 3.52%, and the worst-performing year is -2.69%, while the standard deviation of VGLT is 11.66%, and the worst-performing year is -12.45%. This is where mid-term government bonds win, with lower risk relative to lower returns.
Conclusion
From the perspective of asset allocation, only US treasuries have a protective effect when stock market fall, and there is no reason to necessarily include corporate bonds. As for whether to include investment-grade international government bonds, it is a choice between single-mindedly relying on the United States and resisting decline. However, although bonds are single-mindedly pegged to the United States, if the stock market is allocated to VT, not all assets are allocated to the United States. Finally, the choice between mid-term and long-term US treasuries is a trade-off between returns and volatility. Of course, these choices are not all or nothing, and buying a little of each is also feasible.
Reference
Disclaimer: This article is for informational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities..