In the context of portfolio construction, the best thing about bonds is that they are not stocks. Their cash flows are generally far more certain, their lives finite, their terms transparent, and their rank in the pecking order of companies’ capital structures higher than common equity. All these attributes lend themselves to bonds being less than perfectly correlated with stocks, making them good diversifiers of equity risk. But not all bonds are created equal. Their diversification potential occupies a spectrum from great to lousy. The best diversifiers are the most boring.
As stocks continue to chug along and interest rates have lifted off from their recent lows and could climb higher still, now is a good time to revisit bonds’ role in a diversified portfolio. Here I will look at the degrees of diversification potential offered by various segments of the bond market. Then I will share a peek at recent trends in exchange-traded fund flows among the largest categories of fixed-income ETFs to assess how investors are positioning themselves to cope with the confluence of full stock-market valuations and the possibility of further interest-rate increases.
Ben Johnson, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.