Given the recent stock market volatility, it is a good time to review some of the other parts of a well constructed portfolio. More specifically, the role that Government Bonds play in the management of the overall portfolio. Usually stocks get the most attention as this can be the more exciting part of a portfolio, but there are other more boring parts that deserve equal attention.

 

A good analogy is the foundation of a house. In building a home, more attention to details and choices by the homeowner is normally given to the fixtures, colours, materials etc that will be used in the finished product. Without the foundation however, the stability of the overall home will be at risk. Regardless of how nice the finishing touches are, they will not last long if the home deteriorates and doesn't stand up to changing conditions. Government Bonds form part of the foundation of a solid portfolio.

 

With interest rates being so low, it can be hard to comprehend why one would want to own Government Bonds that will pay little interest. As I write this post, the yield on a Government of Canada 10 year bond sits at 0.57. 10 year US Treasuries have a similar yield at 0.59%₁. It is a fair question to ask why on earth it makes sense to buy a 10 year bond that pays so little interest. The answer lies in the potential protection these investments can offer.

 

In our experience, we have observed several occurrences in the past where stock markets have had a correction or bear market. Most of the time when this happens, the yields or interest rates paid on Government Bonds will decrease. This occurs because capital will flow into Government Bonds which are considered risk free investments in time of crisis. When capital flows in, the prices increase as a result of increased demand. Prices and Yields have an inverse relationship - when prices go up, yields go down.

 

In addition, when the economy slows, Central Banks will normally reduce interest rates and more recently engage in Quantitative Easing (QE) activities. The QE can reduce interest rates on longer term government bonds if the Central Bank is trying to keep interest rates low. 

 

It is good to have some positions in the portfolio that can provide protection in times of crisis. A good example is Exchange Traded Funds (ETFs) which have Government Bonds as the underlying holdings. For example, recently when the US Stock Market declined 35% from February 24th 2020 to March 20th 2020, the iShares US Government Bond ETF (GOVT) increased by approximately 7%₂.  This had the benefit of reducing the volatility in the portfolio, and also being a position that could be trimmed or sold when it was up to free up some cash to buy stocks when they were down. Government Bonds are almost like insurance in the portfolio to protect against crisis. When times are normal and the stock market is moving higher, these investments might not do much. But when stock markets decline you will be happy to have Government Bonds in the portfolio.

 

₁Thompson Reuters. Bond yields as of 10:30am April 29th 2020

₂Thompson Reuters