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Investing

Blog published on February 4, 2019

Why Bonds Matter: Lessons from Behavioral Finance

In recent months, investors have been faced with mercurial market sentiment and rapid fluctuations in stock prices. This volatility was widely seen as out of step with underlying economic fundamentals; instead, non-fundamental elements were taking over the direction of markets. It is likely that declines in liquidity, along with the rise of quantitative trading models and exchange-traded funds, only exacerbated the market’s instability.

In this new era of heightened market volatility, it’s all the more important to understand investor behavior when risk is out of favor. It is also a very fitting time for investors to revisit the purpose of fixed income in a multi-asset portfolio.

Heightened volatility makes it challenging for investors to stay rational, remain patient and exercise good judgment. Focus is shifted from the long-term to the short-term, and negative feedback loops often develop. Market pricing becomes more dependent on human behavior and dislocated from long-term economic fundamentals, sparking more volatility and unpredictability (Figure 1).

Research on behavioral finance bears this out. It shows that investors often make decisions based on loss aversion. The value function from economist Richard Thaler (Figure 2) implies that “… losses hurt about twice as much as gains make you feel good.”1

Spikes of volatility in February and December were emblematic of this dislocation. When equity prices are falling, the human element of investing can start to drive decision-making precisely when it is important for investors to exercise patience and avoid rash choices.

Coping with Unreliable Markets

A bond portfolio can provide a counterbalance to market volatility and an important stabilizing force to help investors stay rational and ride out turbulent markets. It does so in two ways:

1. Counterbalancing equity risk. First, when equities underperform and the market is risk-off, high-quality bonds typically benefit from a flight-to-quality, making the downturn in riskier assets more bearable. Bond prices also may benefit if economic worries produce expectations of lower inflation and a more accommodative monetary policy. An important condition is that the fixed income be up-in-quality, as high yield or higher-risk fixed income sectors typically have riskier credits and higher correlation with equity markets.2

For example, in 2018, municipal bonds were one of the few asset classes worldwide with positive return.3 Also, municipal bond price fluctuations were little different in 2018 versus 2017, despite the significant increase in equity volatility (Figure 3).

2. Providing a Return Independent of the Market. The second way that bonds can help investors cope with volatility is best explained through behavioral finance. A portfolio of individual bonds can offer investors a haven from dysfunctional markets by generating a cash-flow return (coupons and principal) independent of the market.4 Having this more-predictable and reliable return, investors are less likely to feel beholden to the market and thus will be better equipped to weather short-term market volatility.

We believe the benefits of owning a portfolio of bonds directly is supported by Thaler’s findings that investors’ decisions change according to how often they view their portfolio’s performance. Thaler referred to this behavior as “myopic loss aversion.” Investors who see more price fluctuations tend to be more risk averse, while those who are kept in the dark on pricing are better able to remain focused on long-term fundamentals. A bond portfolio achieves much the same result—not by keeping investors in the dark, but by providing a more reliable long-term return, enabling them to focus beyond short-term market fluctuations.

The best evidence of the advantage of owning bonds directly is to examine the behavior of those investors who choose not to do so. Investors in bond funds opt to own shares rather than bonds, which makes them completely reliant on market prices for their capital. As a consequence, data shows that bond fund investors struggle to cope with volatility, often selling and redeeming shares whenever bond prices fall (Figure 4). In contrast, flow of funds data from the federal reserve show individual holdings of bonds have been more likely to increase when bond prices are falling. Clearly, there’s been an advantage for the investors who own bonds directly.

Conclusion

Over the past few decades, our understanding of the importance of behavioral finance has deepened, with some well-respected research that strongly supports the view that investors are not always rational actors and markets are not always efficient. We are not dispensing with the importance of market prices, nor with modern portfolio theory or other economic theories that rely on the concepts of efficient markets or rational decision making. However, we are recognizing that there are more layers to the ways investors make decisions. While most investors have access to fundamental data about the state of the economy, this is not typically the pure driver of investor decision-making; human nature can greatly influence investor decisions as well.

Even investors with long-term goals are short-term evaluators and can make rash, ill-advised decisions in periods of market distress. It is important for investors to have a source of stability in their holdings so that they can remain focused on the long term and avoid costly, short-term missteps when market returns weaken. By holding fixed income separate accounts and owning bonds directly, investors are less likely to be swayed by short-term pricing volatility, as they know that their bonds will mature at par and provide a reliable return.5 

 

 

[1] Richard H. Thaler, “Misbehaving: The Making of Behavioral Economics,” W. W. Norton & Company, First edition, May 2015.

[2] For the year ending January 30, 2019, the Bloomberg Barclays High Yield Index had more than 80 percent correlation with the Russell 2000 index, while the Bloomberg Barclays U.S. Government Credit Index had a less than 60 percent correlation. Sources: Yahoo Finance, Bloomberg Barclays Indices, January 31, 2019.

[3] Bloomberg Barclays Indices, as of December 31, 2018.

[4] Assumes there are no bond defaults. 

[5] Assumes borrower does not default on the investment. 

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