Preparing for Market Volatility: Why Bonds Should Be a Key Component of Portfolios Today

The recent surge in market volatility has shaken investors and left many questioning what it means for portfolios. The VIX — a key measure of expected volatility in the stock market — rose to its highest level in more than four years at the start of August, with global equities falling sharply and bonds rallying.

Recent U.S. economic data has largely confirmed PIMCO's expectation that growth will decelerate from the exceptional pace seen in 2023, leading to a softening of labour market conditions. However, the significant market reactions to relatively minor economic disappointments suggest that markets may have overreacted, with moves not accurately reflecting the fundamentals of the U.S. economy. This behaviour indicates that risk assets, which have been priced for an ideal "goldilocks" scenario, are highly sensitive to any negative economic news.

During periods of heightened market volatility such as this, it is crucial for investors to maintain disciplined portfolio construction principles. This includes ensuring that portfolios contain sufficient diversification to mitigate downside risk associated with growth assets such as equities. With market volatility likely here to stay, we believe bonds can play a vital role in portfolios, offering defence, diversification and income generation.

What does this volatility mean for monetary policy in Australia?

There was speculation towards the end of July that the June quarter Australian consumer price index (CPI) print might prompt the Reserve Bank of Australia (RBA) to hike rates. However, while the headline number rose slightly from the March print, trimmed mean inflation (the RBA’s preferred measure of underlying inflation, which strips out more volatile price movements) eased to 0.8% quarter-on-quarter from 1% quarter-on-quarter.

At its 6 August meeting, the RBA held rates at 4.35% for its sixth straight meeting. It is important to recognise that the RBA's decision to hold rates steady is not an indication of inaction. Maintaining restrictive policy settings gradually erodes household savings and impacts discretionary spending decisions.

In the media release accompanying the August meeting, the RBA noted the recent financial market volatility and stated that it would be relying both on data relating to the domestic economy and the evolving assessment of risks to guide its decisions. This includes paying close attention to developments in the global economy and financial markets. While the RBA has not ruled out rate hikes, we continue to believe that the next move will be a rate cut, given that core inflation appears to be easing and we expect further global volatility.

How can investors best position portfolios for volatile markets?

Many Australian investors are running equity-heavy portfolios with significant cash buffers in the form of term deposits. We believe that in this environment, investors should be considering how to build resilient portfolios and that bonds remains compelling for several reasons:

1. Diversification from equities: A core allocation to fixed income can offer diversification and serve as a hedge against volatility due to the generally low or negative correlation of bonds with other asset classes, particularly in times of economic uncertainty or deflation. Bonds can display positive correlations with stocks in higher inflation environments. However, as inflation returns to central bank targets, correlations between stocks and bonds typically return to being low or negative. In volatile markets such as we’ve seen recently, the diversification properties of bonds become even more valuable.
2. Capital preservation: Bonds can serve as a defensive asset in portfolios. Term deposits and hybrids may occupy a small position in a diversified portfolio, but in our view, they should not replace high-quality fixed-rate bonds. Locking in a fixed-term deposit means forgoing the defensive attributes that bonds deliver in an environment of declining interest rates, such as in the event of an economic slump. Bond prices typically appreciate in a downturn or risk-off scenario, which can help offset losses likely experienced in other parts of a portfolio – namely equities, as earnings decline – making bonds a crucial element of a balanced portfolio.
3. Income generation: Bonds are structured to provide a regular stream of income payments as long as the issuer remains solvent. Although stocks pay dividends, these are at the company’s discretion and are not structurally guaranteed in the same way. High quality core bonds should provide a steady source of investment income even during volatile markets.
4. Starting yields and bond returns: The starting yield on your portfolio today is a strong indicator of the return you can expect on that portfolio over the next three to five years. With the cash rate at 4.35%, bond yields remain attractive making it an opportune time to invest in core bonds. The market is pricing in the first rate cut for next year, but we believe that waiting for that to happen before moving out of cash and into fixed income could mean missing out on potential gains.
5. Daily liquidity: Most bond funds offer daily liquidity, which can be an important factor for investors. On the other hand, term deposits and some private market opportunities lock up money for a fixed period of time, requiring investors to make a “term” decision regarding their access and the interest rate earned. This entails reinvestment risk as well as a lack of flexibility when it might be needed.

Bonds continue to play a key role in a diversified portfolio

From an asset allocation perspective, the outlook for fixed income continues to be constructive. One of the most effective ways of mitigating market volatility is for investors to balance the growth assets in their portfolios with defensive assets such as bonds, which should bolster portfolios in a risk-off scenario when equities and other risk assets decline. Given the current environment of high interest rates and elevated equity market valuations, now is a particularly opportune time to diversify portfolios by adding core bonds.

Find out more about how to access today’s attractive opportunities in bonds here.