Repetition can be comforting at times, as in your morning routine. Lather, Rinse, Repeat. Try to make it until the coffee kicks in. But at times repetition is frustrating or frightening, as in the return of volatility to a market that seemed to have taken a holiday away from the sorts of headline downside moves that make you spit out that morning java. Nevertheless, higher volatility than we have seen over the past few years is the norm, and as investors we should remember that returns are not always positive over the short term. Furthermore, it’s important to incorporate that understanding into your asset allocation.

As a firm, Thornburg Investment Management is dedicated to the pursuit of both the growth and the preservation of wealth, and as a result we think this recent uptick in realized risk provides a good opportunity to talk about the role of fixed income instruments in any well-balanced portfolio. The VIX Index below is a measure of the implied future volatility of the S&P 500 Index, and as a result is a good measure of the expected near term jumpiness of stocks. It is, for this reason, also known as the “fear gauge.”

Volatility and price movements are a fact of any marketplace. Changing news flow, fundamental realities and technical positioning all play a part in moving asset prices over the course of days, months, and years. Recently, concerns about the health of the U.S. housing market and its attendant effect on the economy as a whole have erased the YTD gains in stocks globally and have reminded us all that despite our rosy experience in the second half of 2006, prices in all markets can move quickly and, in some cases, painfully.

So how do you guard against large swings in the value of your portfolio? One way is introducing, or increasing, the percentage of high quality fixed income in your holdings. As shown in the chart below, highly rated fixed income holdings not only have lower volatility, but also give you a higher return than equities when adjusted for risk over a given time period.

Sharpe ratio divides the excess return on an asset over cash returns by the price volatility of that asset. So a very high volatility asset with mediocre returns would have a much lower Sharpe ratio than a low volatility asset with very high returns. The Sharpe ratio of stocks or bonds varies significantly depending on what time period is sampled, but a sample of the last 10 years (using annual samples rolling monthly) provides some interesting results. In the chart you can see both the average annual return, the one standard deviation band of annual returns, and the Sharpe ratio of each asset. Higher quality fixed income assets show lower returns than stocks, but have much lower volatility. As a result, their risk adjusted return, as measured by their Sharpe ratio, is higher than low quality bonds or stocks. In other words, the return of high quality fixed income, coupled with its relatively low volatility, makes for a powerful addition to your asset class opportunity set.

Combine the risk/return profile of high quality bonds with a negative correlation to equities, and fixed income presents you with

1) periodic income
2) low volatility/price risk
3) good diversification potential.

One further note: low quality, “high yield” bonds can be appropriate for some situations and can offer some good investment opportunities. However, they have a much higher correlation with equities and a much lower risk-adjusted return than high quality bonds. As a result, “high yield” is not a stand-in for the fixed income portion of your portfolio.

While high quality bonds will in general underperform stocks over a long period of time, depending on your situation or viewpoint, you may not be able to or wish to stick it out through a long period of stock underperformance. The 2000–2006 time frame, despite an extremely strong series of stock returns over the past few years, has seen bonds outperform stocks due to the bear market early in the decade. While this fixed income outperformance is unusual and will no doubt be erased over time by higher trending equity markets, your investment time frame may be shorter than the three, five, or even 10 years it might take for stocks to regain the upper hand. In addition, because bond funds typically offer a more stable net asset value (NAV), they are more dependable for planning purposes if you have a need for cash in the short to medium term.

Let’s take a look at the performance the S&P 500 Index over the past 10 years (ending 12/31/06) vs. the performance of a 50/50 combination of the S&P 500 Index and the Lehman Aggregate Bond Index (a high grade only bond index covering many portfolios). That 10-year period covers both bull and bear markets for bonds and stocks. It has the further benefit of having a fairly robust data set as well as being fresh in all of our minds. Over that 10-year period, the S&P by itself returned 8.42% annualized, while the 50/50 stock/bond combination returned 7.81%. So you’re better off in stocks, right? Maybe not. That extra 0.60% in return came at a significant volatility cost. The S&P 500 had a standard deviation of 17.27% (meaning that about one sixth of the time your return was less than negative 8.85%) whereas the 50/50 combination portfolio had a standard deviation of only 8.07% (meaning about one sixth of the time your return was less than negative 0.26%). While you made a touch more money investing in long only stocks, you had a much wider dispersion of returns, i.e. sometimes you had to look at an uglier statement. The Sharpe ratio (again, a measure of risk adjusted return) increased with the combination portfolio to 0.51 from 0.28 with just the S&P 500.

We’ve gone through a bunch of scenarios, returns, and terms, but the bottom line is that you should take a look at your portfolios to see if you have a need for the lower volatility and more dependable returns that your favorite bond fund may give you. The business cycle is not dead and returns on riskier assets (i.e. stocks) will mostly likely show more volatility in the future than they have over the past few years. Many may think of bonds as an alternative to cash, but appropriate asset allocation for many investors will include bonds as a powerful addition in their own right. Bond funds may not be appropriate for every situation, but they certainly make sense to add to your list of potential investments.

If you have factored in the downside protection that high grade bonds can give your portfolio, the repetition of higher volatility need not be so painful. The “rinse, lather, repeat” cycle will be confined to your mornings and you’ll keep your portfolio from taking a bath.

About the Author
Jason Brady, CFA joined Thornburg in 2006 and was named managing director in 2007. He is portfolio manager of the Thornburg Limited Term Income and Thornburg Limited Term US Government Funds and co-portfolio manager of the Thornburg Investment Income Builder Fund. Prior to joining Thornburg, Jason was a portfolio manager with Fortis Investments in Boston, and has held various positions at Fidelity Investments and Lehman Brothers.  

The views expressed by the author reflects his professional opinions and should not be considered buy or sell recommendations. These views are subject to change.

Important Information
Shares in the funds carry risks including possible loss of principal.   As with direct bond ownership, funds that invest in bonds are subject to certain risks including interest-rate risk, credit risk, and inflation risk. The principal value of bond funds will fluctuate relative to changes in interest rates, decreasing when interest rates rise. Unlike bonds, bond funds have ongoing fees and expenses. Shares in the fund are not deposits or obligations of, or guaranteed or endorsed by, any bank, the Federal Deposit Insurance Corporation, the Federal Reserve Board or any government agency.

Investing in fixed-income strategies does not assure or guarantee better performance and cannot eliminate the risk of investment losses.

High yield bonds may offer higher yields in return for more risk exposure.

Standard Deviation – A statistical measurement of dispersion about an average which, for a mutual fund, depicts how widely the returns varied over a certain period of time. Investors use the standard deviation of historical performance to try to predict the range of returns that are most likely for a given fund.  When a fund has a high standard deviation, the predicted range of performance is wide, implying greater volatility.

Lehman Brothers Aggregate Bond Index – An index composed of approximately 6,000 publicly traded bonds including U.S. government, mortgage-backed, corporate and Yankee bonds with an average maturity of approximately 10 years. The index is weighted by the market value of the bond included in the index. This index represents asset types which are subject to risk, including loss of principal.

Standard & Poor’s 500 Stock Index – An index consisting of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large-cap universe.

NASDAQ Composite Index – A market value-weighted, technology-oriented index comprised of approximately 5,000 domestic and non-US-based securities.

The performance of any index is not indicative of the performance of any particular investment. Unless otherwise noted, index returns reflect the reinvestment of income dividends and capital gains, if any, but do not reflect fees, brokerage commissions or other expenses of investing.  Investors may not make direct investments into any index. 

This material is for financial advisors and institutional clients only.