After almost four years of false alarms, the bond bears are finally able to act smug. Broad-based Canadian bond index funds have fallen in price about 4% or so in since the beginning of May. Meanwhile, real-return bonds have taken it on the chin: they’ve plummeted about 13% and are headed for their worst calendar year since first being issued by the federal government in 1992.
In times like these investors question the whole idea of including these asset classes in a balanced portfolio. So it’s time for a reminder about how diversification is supposed to work.
It’s helpful to think about a portfolio like a cake recipe. You probably wouldn’t eat flour, baking powder or raw eggs on their own, but when you mix them with sugar, butter, vanilla and other ingredients the results are delicious. A baker doesn’t view ingredients in isolation: she considers how each interacts with the others to produce the final result.
In the same way, it’s important not to view individual asset classes in isolation. Real-return bonds are a perfect example. It would be hard to make a compelling argument for holding nothing but RRBs: their yields are low,