Nobody talks about bonds much anymore. For decades, the classic combination of 60% stocks and 40% bonds made for a strong investment strategy — the undisputed champion of balanced investing. A team so reliable it was a dynasty.
But in recent years, a volatile economic climate has triggered an unprecedented positive correlation between stocks and bonds, leading many to declare the old playbook dead. Yet, to dismiss bonds entirely would be a monumental mistake. While their role has undoubtedly evolved, they remain an indispensable pillar of a modern investment portfolio, providing crucial stability, income and diversification that can help cushion a portfolio against market volatility.
Historically, bonds were often viewed as the safer counterpart to stocks. When you buy a bond, you are essentially lending money to an entity — a government, municipality or corporation — in exchange for regular interest payments and the return of your principal at maturity. This fixed-income nature makes them fundamentally different from stocks, which represent ownership and whose value fluctuates with a company’s fortunes.
For centuries, bonds were the preferred asset for institutions like pension funds and retirees seeking predictable, low-risk income. They were the capital preservation engine of a portfolio, a place to park money where it would be safe and generate a steady stream of cash.
In times of economic uncertainty or market downturns, investors would flock to high-quality government bonds, like U.S. Treasuries, as a safe haven. This flight to quality would drive up bond prices and push down their yields, acting as a natural counterbalance to falling stock prices.
This inverse relationship between stocks and bonds was a fundamental tenet of portfolio construction for decades. If the economy was slowing and corporate profits were expected to decline, stock values would typically fall. In response, central banks would often lower interest rates to stimulate the economy, which in turn would make bonds with higher fixed interest rates more attractive, driving their prices up.
This negative correlation meant that as one part of a portfolio suffered, the other would often thrive, smoothing out the overall returns and reducing volatility.
The rise of modern portfolio theory
The historical role of bonds was formalized and amplified by the development of modern portfolio theory (MPT) in the 1950s by economist Harry Markowitz. MPT provided a mathematical, holistic framework for assembling a portfolio of assets to maximize expected return for a given level of risk. The key insight of MPT was that an investment’s risk and return should not be assessed in isolation, but rather in how it contributes to the overall portfolio.
MPT popularized the concept of diversification, emphasizing the importance of combining assets with low or negative correlation. A portfolio with 100% stocks, for example, is highly exposed to the risk of a market-wide downturn.
By adding bonds — an asset class that historically moves differently from stocks — an investor could achieve the same level of return with less risk, or a higher return for the same level of risk. This is the essence of the efficient frontier in MPT.
For many years, the classic 60/40 portfolio was the gold standard for a balanced investment strategy. It was a simple yet powerful application of MPT, designed to capture the growth potential of the stock market while using bonds to provide stability and act as a hedge during turbulent times.
This allocation became a staple of financial advice, a testament to the perceived reliability of bonds as a portfolio stabilizer.
The bond market’s modern challenge
The conventional wisdom surrounding bonds faced a significant test in the 2020s. Following the 2008 financial crisis, central banks around the world engaged in quantitative easing and kept interest rates at historic lows for more than a decade to stimulate economic growth. This made bonds less attractive from an income perspective. With yields near zero, the income portion of the bond’s value proposition was largely diminished.
Then, a new challenge — inflation. As it surged, central banks began aggressively raising interest rates to bring prices under control. Bond prices plunged. Both stocks and bonds experienced significant declines simultaneously, breaking the long-held negative correlation and causing unprecedented losses for investors in supposedly balanced portfolios.
It was a painful period for bond investors that led many to question their relevance. If bonds no longer provided income and were no longer a reliable hedge against stock market downturns, what purpose did they serve?
The 60/40 portfolio was declared dead by some, and many investors fled to cash or other alternative assets.
The new case for bonds
Bonds are far from obsolete. Their role in a modern portfolio has simply evolved and is now arguably more complex and nuanced than ever before. The core reasons for holding bonds — diversification, income and capital preservation — remain valid.
First, while the stock-bond correlation turned positive for a period, it has historically been negative and is expected to return to its inverse relationship eventually.
The period of high inflation and rapid interest rate hikes appears to be an anomaly, not the new normal. For long-term investors, the diversification benefit of bonds is still a powerful risk management tool.
Second, the aggressive interest rate hikes of the mid-2020s have brought a significant silver lining for bond investors: higher yields. Yields are now at levels not seen in over a decade, making bonds once again a compelling source of income for investors.
For those nearing or in retirement, this is a critical component of their financial plan, providing a predictable cash flow that can help cover living expenses.
Finally, bonds still offer a measure of capital preservation that stocks cannot. While bond prices can fluctuate in response to interest rates, holding a high-quality bond to maturity will guarantee the return of your principal — barring a default by the issuer.
This is a crucial distinction from stocks, where the principal investment is never guaranteed. This stability is invaluable for managing a portfolio’s overall risk and providing a psychological cushion during market downturns.
Bonds may not always be the hero they were in the past, but they are still essential. They function as defensive players, the ones who may not score the most points but are indispensable for protecting against a loss.
Investors shouldn’t be questioning bonds in their portfolio. They should be asking their advisor which ones they should own. With a variety available, from short-term government securities to high-yield corporate bonds, investors can tailor their fixed-income allocation to their specific goals and risk tolerance.
The 60/40 rule may be a relic of the past, but the underlying principles of balanced investing and diversification — with bonds in the mix — are more relevant than ever.
Pat Bolland is head of advisor recruitment at Justwealth Advisor Services