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Why Bonds Deserve to Stay in Your Portfolio

Good Reasons You May Want to Be in—and Stay in—Bonds

(Continued from Prior Part)

Top three reasons to retain bonds

Investors look to bonds to meet a number of key financial goals. These are the top three:

1.Diversification.

This should always be on everyone’s list. Bonds help serve as a true diversifier to a stock portfolio, meaning they almost always react differently to economic and financial conditions. If you go back to 1926 (88 years), stocks were negative in 24 calendar years. Bonds were negative in only two of those years. That divergence can help smooth out your overall returns, and add a cushion when stocks go down.

Market Realist: Bonds deserve to stay in your portfolio. They offer a great cushion when equities underperform.

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The graph above shows the correlation coefficient between stocks, as represented by the SPDR S&P 500 ETF Trust (SPY), with long-dated Treasuries (TLT), investment-grade corporate bonds (LQD), and high yield bonds (HYG), considering weekly returns over the past ten years.

The correlation coefficient always lies between +1 and -1. A correlation of +1 implies that the two securities move in lockstep with each other. A correlation of -1 means exactly the opposite. A correlation of 0 between two assets is ideal.

Treasuries are the safest of the four assets. They’re backed in full by the US government and have no credit risk or the risk of default. Investment-grade corporate bonds carry some credit risk, but they’re relatively safe. High yield bonds are the riskiest of bonds and carry the most credit risk.

As the graph shows, equities and Treasuries move in somewhat opposite directions, with a correlation of -0.4. This is because equities (IVV) are considered risky while Treasuries are considered safe. An event that would put economic growth at risk would trigger a move from equities to Treasuries.

The correlation between equities and high yield bonds is quite high, at +0.7. This is because both equities and high yield bonds depend on the well-being of the economy.

Investment-grade corporate bonds fall between high yield bonds and Treasuries. Though investment-grade corporate bonds are big companies that have the ability to service debt, these bonds may not be as safe as the Treasuries. The correlation between stocks and LQD is +0.1, which is good.

Bonds provide diversification benefits because they behave differently than stocks. This makes them attractive, since they reduce the volatility of your portfolio and increase your risk-adjusted returns.

Continue to Next Part

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