Many commentators have been casting doubt on whether a private investor should bother allocating to bonds in their portfolio, with yields low by historic standards.
However, our data shows that an investor who diversified into bonds would have made more than one who put it all in equities right up until last spring, underlining the importance of diversification between asset classes.
The data suggests that investors need to think carefully before jettisoning their bonds.
According to FE data, a portfolio of 20 per cent in sterling-denominated bonds and 80 per cent in the All Share would have returned 44.73 per cent over seven years while the FTSE All Share made 45.35 per cent.
Putting 40 per cent in bonds would have returned almost exactly the same amount – 44.13 per cent – but with significantly lower volatility.
Performance of portfolios vs equities over 7yrs
Source: FE Analytics
In fact, the portfolio with 40 per cent in bonds has half the volatility of a full allocation to equities. The annualised figures are 10.44 per cent to 20.4 per cent respectively.
The portfolio with 20 per cent in bonds has a volatility of 14.99 per cent. This is reflected in the Sharpe ratio, a measure of risk-adjusted returns: the portfolio with 40 per cent in bonds has the highest Sharpe ratio, meaning that it achieved the best returns per unit of volatility taken on.
The figure is almost double that for the equities-only portfolio.
Source: FE Analytics
Looking at volatility and maximum drawdown – the most you could have lost if you had bought and sold at the worst times – is especially useful for investors who don’t know when they want to draw down their investment, which is likely to include most people.
While five-year figures may make it seem there is little point in holding bonds, up to last June you would have been better off with a mixed portfolio if you had put your money in close to the 2007 market peak and had to take your money out.
Looking over seven years allows us to look over a whole market cycle. Five-year performance figures now show only the rebound in equity markets since its bottom in March 2009.
The figures look very different, with the equity-only portfolio up 140.83 per cent compared with 107.1 per cent to the 20 per cent in bonds portfolio and 81.82 per cent for the 40 per cent in bonds portfolio.
Performance of portfolios vs equities over 5yrs
Source: FE Analytics
Last week FE Trustnet highlighted the danger of looking at fund performance over five years, now that the last peak and correction in the cycle have passed, and the figures suggest this also holds for asset classes.
Scepticism about bonds centres on the 30-year bull market which has seen yields steadily fall since the 1970s.
However, a similar point could have been made just before the dotcom crash, after a 20-year bull market in bonds.
Our data shows that a mixed portfolio would have outperformed during this period and the subsequent recovery.
Performance of portfolios versus equities 1999 – 2004
Source: FE Analytics
It was only a few months after the equities portfolio crept ahead of the mixed portfolios that the market fell, the same situation we are in today.
A graph of relative performance against equities clearly shows the periods in which bonds have outperformed, and it is no surprise these have been during market corrections.
Relative performance of sterling bonds to equities since 1998
Source: FE Analytics
The concerns about bonds centre on whether the current good news around the economy is likely to lead to interest rate rises, pushing yields higher and prices lower.
Charles Montanaro, manager of the Montanaro Equity Income fund, said: “If you believe history does tend to repeat itself, the likelihood of yields falling much lower is extremely unlikely.”
“Interest rates are likely to rise just as growth is starting to improve and pension funds are underweight equities.”
Montanaro says that he expects 5 per cent yields on the government bond market once more, and that therefore the relative attractiveness of the asset class for income-seekers to his own equity income sector will improve.
However, our data highlights that when markets fall, bonds have continued to offer some protection.
In October and February, equities fell and bonds produced superior relative performance.
The data suggests that for anyone with a long-term view, investing over at least one full market cycle, retaining a weighting to bonds in your portfolio is a sensible option.
Click here to learn more about bonds, with the FE Trustnet guide to fixed interest.
