How Bonds (Should) Provide Diversification

Photo by Tima Miroshnichenko

The US Stock market has essentially been on a 15-year run with little interruption. From 2010 through 2019, the S&P 500 index of the largest US Stocks saw some of the usual corrections of around 10% to 15% every couple of years. Still, the trend was generally up and to the right with 2018 being the only negative calendar year when dividend reinvestment is included in the returns. 2020 came with a very sharp downward crash early in the pandemic, a steep recovery out of the bottom, and we were back off to the races again. 

Much of this decade-long rally had to do with the idea of “easy money.” Bond interest rates—and therefore consumer and business borrowing costs—started off the decade low and went lower. The 10-year US Treasury bond yield was just below 4.00% to start off the 2010s and was just under 2% at the end of 2019. All of this cheap borrowing helped supercharge the economy, the housing market, and the stock market. 

2022 brought us the first real bear market with a prolonged downturn of 20% (I am dismissing the 2020 pandemic-related bear market because it lasted a mere month.) The cause of that downturn? In many ways, it was the reverse of the 2010 bull market: Inflation heated up as we came out of the pandemic with an economy and supply chain that was way out of whack, and the Federal Reserve raised interest rates sharply, taking the wind out of the consumer and the business owner’s sails. Back to our 10-year treasury - the yield started the year in 2022 at under 2% and rose to finish the year at just under 4%. If you were in the market to buy a house in 2022, I don’t have to tell you what that did for mortgage rates. 

But I am here to tell you that all’s well that ends well. At least when it comes to portfolio diversification. Borrowing for a home or a car might be a different story. 

Bonds provide diversification and “shock absorption” against the stock market in a couple of ways:

• Increases in value when interest rates drop
  
  • The price or value of a bond and overall interest rates move in opposite directions. Imagine a see-saw. When one side goes up, the other side goes down. 
  • Why is this? Imagine you own a bond that pays 5% per year. Interest rates drop, and new bonds only pay 3% per year. Without going into the details of the math, it’s easy to see that the bond paying 5% per year that you hold is worth more than a bond only paying 3% per year that someone could buy today. 
  • Why does it matter? Often, in a weakening economy, the Federal Reserve lowers interest rates to stimulate the economy. If you hold bonds and interest rates drop, you’ll likely see an increase in value, offsetting some of the weakness in your stock portfolio. 
• The “flight to safety”
  
  • If you watch enough financial TV (which I don’t recommend consuming too much of), you might hear the term “flight to safety.”
  • In tumultuous times of stock market volatility, investors might seek relatively safer assets and move money into bonds and money market accounts, and away from stocks. 
  • Why does it matter? Like any asset, the more people want to buy something, the more it increases in value. Again, if you are already an owner of some bonds in your portfolio, this increased demand could increase the value of your bonds, offsetting some of the stock market volatility. 
• Regular Income
  
  • Bonds are, in theory, supposed to pay consistent, stable income. That’s where most of their return is expected, and it’s a great benefit to retirees and others who want a stable income from their portfolio.
  • This was another big problem in the ultra-low interest rate environment of the 2010s. With 10-year bonds yielding under 1% at times and shorter-term bonds paying even less, there just wasn’t much income coming in to offset any market losses. 
  • With the 10-year treasury currently yielding around 4% (in March 2025), that is a much higher starting point for your return and will go a little more towards offsetting declines in your stock portfolio. 

When the bear market in 2022 came around, years of ultra-low interest rates meant bonds could not do one of their main jobs—diversify and absorb the shock of a declining stock market.

• Interest rates had only one direction to go—up, which led to declines in bond values for investors. 
• Yields were super low, providing little added value to portfolios. 
• While the “flight to safety” was happening to some degree, it wasn’t enough to offset the steep increases in rates, which led to steep declines in bond value. Furthermore, the increases in bond yields were keeping many from buying bonds in the first place out of concern that rising rates would damage their returns.

As a result, 2022 was the worst-returning year for bonds as a whole in over 30 years. It was also the only time in the last 30 years that both the S&P 500 and the aggregate bond index were down in the same year. Over this time, every other down year for the S&P 500 was met with a positive year for bonds. Having both stocks and bonds down in the same year was an unusual event, and it made navigating the investment world particularly challenging. 

So, are bonds back? We can’t predict the future, but bonds are certainly in a better position to be a shock absorber than they were two years ago. So far this year, the S&P 500 is down 2.22% as of March 6th, and the aggregate bond index is up 2.27%, providing the buffer exactly as it should. If you are an aggressive investor with an 80%+ stock allocation, this should dampen downturns and provide some extra funds to shift to stocks if the drop continues. For a more conservative investor with a 50% or 60% stock allocation, it should provide a much smoother ride despite the scary headlines and a little more income in your pocket along the way. 

Contrary to some opinions, a diversified portfolio is still essential to your investment plan. If you have questions about building the right portfolio for your needs and preferences, schedule a free intro call to talk more.