Worried about stock market volatility? Bonds are here to soothe your nerves

Spare a moment for bonds – not because they’ve been sputtering in recent months, but because they’re looking like an increasingly attractive alternative to stocks and cash as the year winds down.

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Oh sure, you’ve heard this before.

Declining inflation and slow economic activity were going to reward bond investors in 2024 as central banks slashed their key interest rates from multiyear highs, according to many observers at the start of the year.

At least one part of this forecast has unfolded according to plan: This week, the Federal Reserve cut its rate by a quarter of a percentage point, bringing the total reduction to a full percentage point since September. Last week, the Bank of Canada lowered its key rate to 3.25 per cent, in its fifth cut since June.

But while monetary policy is working in bonds’ favour, bonds have not been living up to expectations.

The yield on the 10-year U.S. Treasury bond, which reflects investors’ opinions of where interest rates and inflation are heading, approached 4.6 per cent on Thursday. The yield, which rises as bond prices fall, is not far from its 2024 high of 4.7 per cent, in April, months before the Fed began to lower rates.

What this means for typical investors who have bonds in their portfolios: The iShares Core U.S. Aggregate Bond ETF, a popular exchange-traded fund that provides quick-and-easy exposure to the U.S. bond market, is down 2.3 per cent in 2024, not including distributions.

The part that really stings is that the ETF – and other broad bond funds like it – has underperformed the S&P 500 by about 25 percentage points. Even after distributions are included, bonds are likely a drag on your portfolio.

Despite this, they also look like a natural counterweight to stock market volatility amid concern that equity valuations are at nosebleed levels. The Fed’s suggestion on Wednesday that further rate cuts may be slower to come next year, amid simmering inflation and the threat of trade tariffs, only adds to the appeal of bonds as a safer alternative to stocks.

Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, believes the U.S. economy could be shifting toward a “reflationary” period where government policy stokes economic growth but also supports inflation, posing a risk to stocks.

Worse, growth could stumble if there is a policy mistake, creating an environment of stagnating economic activity and persistent inflation, or “stagflation.”

“Equity investors don’t seem to have embraced that view yet,” Ms. Shalett said in a note.

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Running from stocks might not be the best approach, given that no one knows where things are headed in the near term. However, diversifying into other assets might not be a bad idea.

Bonds are especially appealing right now for a number of reasons, as noted this week by two voices from asset-manager PIMCO, Richard Clarida, global economic adviser, and Mohit Mittal, chief investment officer of core strategies.

Attractive starting yields offer a strong indicator of long-term fixed income performance. High-quality bonds tend to perform well during soft landings, when central banks manage to tame inflation without triggering a recession. Bonds offer a nice cushion when investors start focusing on economic downturns and equity market turbulence, Mr. Clarida and Mr. Mittal said in their note.

And, bonds are cheap when current yields are compared with the sky-high equity valuations reflected by Robert Shiller’s cyclically adjusted price-to-earnings ratio. This approach to valuations, which uses 10-year profit figures to smooth out unusual periods, suggests that U.S. stocks currently trade at more than 37 times earnings, or not far from their 1999 peak.

“Looking back at bond and equity markets on average since 1973, during periods when U.S. core bonds are yielding around 5 per cent or greater while U.S. equities’ earnings ratios are above 30 – as they are today – bonds have offered higher five-year subsequent returns, and with potentially lower volatility,” Mr. Clarida and Mr. Mittal write.

Equity market turbulence is picking up. The S&P 500 fell 2.9 per cent on Wednesday, suggesting investors were spooked by the Fed’s new tone on interest rates. On the same day, the Dow Jones Industrial Average notched its tenth consecutive decline, for its longest losing streak in 50 years.

Maybe this volatility will subside. Maybe high equity valuations can persist for a lot longer. But bonds offer a low-risk alternative to a lot of what-ifs.