Disclaimer: Lean Investments is a financial education and entertainment website. None of the content below should be misconstrued as investment advice or a recommendation. The author holds none of the positions mentioned below.
Quick summary: Bonds have a stodgy reputation and the current environment does not appear to favor them. However, bonds play a pivotal role in the popular 60/40 portfolio and some types of bond ETFs such as TLT have shown negative correlation with the S&P 500, making it a good potential diversifier for a portfolio heavy in stocks.
Introduction: A Brief Overview of Bond Investing
You may have come across various bond ETFs on Robinhood and wondered how useful they can be in your portfolio. The vast majority of bond strategies will feature comparatively low returns against almost any stock ETF.
Historically, bonds have been coveted for their ability to produce yield, or income. This makes them appealing to older and retired investors who depend on steady income and prefer to avoid the volatility of stocks.
However, since 2008, most types of bonds have offered very low yields with a few exceptions including high-yield and emerging markets bonds, both of which tend to be riskier than mainstream treasury or investment grade bonds.
However, low returns and minuscule yields are only one side of the story. Typically, most types of bonds are less volatile and risky than stocks. Certain bond ETFs, such as TLT, also have shown some negative correlation to US stocks, particularly during times of market crises. This can make some types of bond ETFs potentially useful for diversification purposes.
The TLT bond ETF tracks long-term treasury bonds of 20 year duration or more. During the 2020 stock market panic, dating from February 10 to April 20, TLT gained more than 20% at a time when global stocks dropped more than 30%. A similar phenomenon occurred in 2008, when TLT returned returned more than 33%, while stocks faced one of their worst years in history, dropping more than 36%, according to annual return data from Yahoo Finance.
The above examples show that while holding bond ETFs will almost always lead to long-term underperformance compared to stocks, there are times such as market crashes where you may be relieved to hold some part of your portfolio in bonds.
Below we look at some common use cases for holding bonds and how to access bond ETFs on Robinhood.
Common Use Cases for Bonds
If you are a young investor looking to start to build wealth, bonds should likely have a limited role in your portfolio. While stocks are inherently riskier and more volatile, some financial experts note that younger investors with long investing time horizons are able to ride out the ups and downs of the stock market in order to achieve historically higher returns than offered by bonds, precious metals or most other asset classes that have not been able to match stocks long-term returns.
Additionally, most bonds’ current historically low yields, and the potential for a steady, long-term interest rate rises makes it difficult to advocate for bonds in the current environment, especially for younger investors in the accumulation phase of their investing journey.
As you continue to grow your portfolio however, bonds may become more relevant to your situation. Below are some common use cases for utilizing bond investing strategies.
1. The 60/40 portfolio
The 60/40 portfolio is one of the most common investment strategies for many types of long-term, passive investors. This portfolio allocates 60% to stocks, such as an S&P 500 or Total Stock Market Index, while putting 40% into bonds. The most common selection for the bond allocation is an ETF such as AGG, or another similar total bond market index fund. This type of fund gives an investor exposure to all types of bonds from investment grade corporate bonds, mortgage bonds, treasuries and some high-yield issues.
The idea behind the 60/40 portfolio is to capture a solid portion of the upside of the stock market, while have a cushion in the form of bonds to better help investors ride out those rough periods like 2008 and the 2020 market crash.
According to Marquette Associates, the 60/40 portfolio dropped 20% in 2008, compared to a 37% loss for an all-stocks portfolio. The study found similar notable outperformance during the early 2000s tech stock crash and 2013 Taper Tantrum. While a 60/40 portfolio trailed the S&P 500 in total return by about 4% annualized, it did so with much less volatility and a better Sharpe ratio, indicating 60/40 investors suffered through fewer and less steep declines over a ten year period.
A 60/40 portfolio can potentially be a good option for anyone who feels wary about the stock market’s roller coaster ride of ups and downs. It can work well for older investors who are more concerned about preserving their accounts or anyone who has a history of selling out of stocks from fear (including all the folks who sold at the bottom in the 2020 sell-off, only to miss the massive rally that followed).
Historically, data shows that the 60/40 portfolio has been a good way to capture solid market returns above inflation without suffering through the worst effects of market crashes and sell-offs. Younger investors willing to accept more volatility for potentially higher returns may want to apply these principles in a more aggressive mix, such as 80/20 (stocks to bonds).
The most important aspect to keep in mind when pursuing a 60/40 portfolio is ensuring you select the correct bond ETF for your portfolio. You do not want bond ETF that only focuses on corporate bonds, as corporate bonds can be more correlated to stocks during times of market stress. Investors interested in a 60/40 mix should select a broad-based total bond market ETF such as AGG, which is available on Robinhood.
2. Short-term or conservative investing goals
There are many situations where you may have a short-term investing or savings goal such as a house down payment or buying a new car where you would like to achieve gains higher than the paltry interest available on savings accounts or CDs, but do not want to take on the market risk of 100% stocks. For those willing to take some risk with their money, short-term bond funds can potentially play a role in these situations. Short-term bond funds are designed to generate a small return with limited (but not no) downside risk.
A typical example is the SPDR SSga Ultra Short-Term Bond Fund (ULST), which is available on Robinhood. The fund invests in a mix of very short duration treasury and corporate bonds as well as cash equivalents. The returns have varied from more than 3% in 2019 to just 0.25% in 2021. In the last 5 years, the fund has returned 1.54% annualized according to Morningstar performance data.
While a 1.54% annual return over five years seems quite low, it’s still represents a higher return than leaving your money in a savings account over that period, when most savings accounts have returned well under 1%. The current average savings account is paying just 0.06% in interest, while a CD, which unlike a bond ETF, requires you to lock up your money for at least a year, is paying just 0.16% on average, according to Bankrate data at the time of writing.
There are many more short-term and ultra short-term bond ETFs available on Robinhood, including ones that just focus on a certain type of bond such as high-yield or mortgage bonds. While these options may offer slightly higher returns, they also have the potential to lose money in any given year, something you don’t have to worry about with a CD or savings account.
If you’re considering a short-term bond ETF, speak with a financial advisor or plug the ticker into Morningstar to see the annual returns over the past ten years. This will give you an idea of the annualized returns and also how good the ETF is at avoiding losses on an annual basis.
3. Deflationary or declining interest rate environments
There are times when the economic environment can favor holding bonds as a strategic investment for total return. This is typical when the economy is experiencing the threat of deflation or a prolonged cutting of interest rates. During the period of 2014 – 2020, when interest rates were held low, the bond ETF TLT returned an impressive 9.5% annualized, according to Morningstar. That is particulalrly strong return considering that treasury bonds do not have equity risk (like stocks) or credit risk (like corporate bonds).
However many market observers and economists forecast that the glory days for holding bonds as a strategic investment are over, at least for now. The Fed is concerned about inflation, rather than deflation, and has indicated their intention to raise interest rates in the near future, an action that will be negative for the price of bonds going forward.
To understand the important relationship between rising interest rates and the value of bonds, review this article.
Popular Bond ETFs on Robinhood
Below are the tickers of some popular bond ETF options and a brief explanation of their investment objectives. None of these options are a recommendation from Lean Investments and it’s important to understand that just like stocks, bonds past performance does not represent a guarantee of future returns.
AGG – Tracks the Barclays Bloomberg Aggregate Index. One of the most popular ways to capture a broad based exposure to mainstream bonds and is a common option for the bond portion of the 60/40 portfolio discussed above.
TLT – Long-term treasury ETF. While volatile in its own right, has shown some negative correlation to stocks, particularly during times of market crashes. Its extreme duration makes it vulnerable to interest rate moves and not an ideal option to in a prolonged rising rate environment. Potential for double digit annual gains and losses depending on the environment.
TIP – This ETF invests in inflation protected treasury securities and will rise and fall in value with the level of inflation. If you are concerned about inflation, this could be a reasonable option for a small part of your portfolio.
LQD – A popular option for investing in corporate bonds. Lower volatility and lower return profile than stocks, however this type of strategy can still experience losses during times of stock market stress as it is closely tied to the health of the corporations that issue the bonds.
JNK – This ETF represents a base of high-yield (or junk) bonds. These bonds represent companies that are rated low by bond rating agencies due to economic stress, some of them have the potential to go bankrupt. Mong bond strategies this is a higher risk and potentially higher reward play.
EMB – Emerging market bonds that this ETF and others invest in offer adventurous investors a way to invest in bonds of developing markets like Brazil and India. Expect close to stock-like volatility as well as additional unique risks associated with emerging markets, such as wildly fluctuating currencies. Definitely worth researching before you dive in.
Bonds are typically not the first option for new or younger investors seeking to grow their portfolios. Additionally, the current macroeconomic environment of historically low yields coupled with the potential for higher interest rates in the future make most types of bonds unattractive from a potential risk/return standpoint. However, as we have noted some bonds can still offer portfolios a cushion during times of volatile stock market declines and the 60/40 portfolio remains a key strategy for risk-conscious investors.
Before investing in any type of bond ETF, make sure you understand the specific risks and return potential of the ETF so you are not surprised by a steep loss or chronic low returns. While bonds are typically considered “safer” than stocks they can, and do, lose money in various market environments. The only truly risk-free place for your money is an FDIC insure back account.