Back on March 25, I wrote a post called The Bond Dilemma that described how nervous fixed-income investors were in early 2010. The Bank of Canada had strongly suggested that it would raise interest rates later in the year, and I was receiving a number of emails from people who said it was foolhardy to invest in bonds, which seemed almost guaranteed to lose money.

The year isn’t over yet, but once again the conventional market predictions seem to be wrong. We did get two small interest rate hikes this year, and yet bonds have been one of the best-performing asset classes so far in 2010. While stocks in developed markets are treading water, bond index funds are up over 5%. They’re the only reason balanced investors have had positive year-to-date returns, despite all the forecasts about how bonds were certain to get killed.

Bonds have a reputation for being boring, even a bit stodgy. Yet the performance of Canadian fixed income has been excellent for three decades. In the 1980s, steadily falling interest rates created a huge bull market for bonds. During the 1990s, when US stocks were shooting the lights out and getting all the attention, Canadian bonds averaged returns over 10%. Then, through the terrible 2000s, bonds gave investors annual returns around 6%, trailing Canadian equities by only 1% per year, and soundly thumping US and international stocks, which were negative for the decade.

Through it all, it sometimes seemed like bonds didn’t even show up on the radar. When things hit the fan in 2008, how many market commentators proclaimed asset allocation dead because “everything went down together”? They apparently didn’t notice that a conventional balanced portfolio — such as the Global Couch Potato — includes 40% bonds, and the DEX Universe Bond Index was up 6.4% in 2008. Government of Canada bonds topped 11% on the year. Investors with that traditional 40% bond allocation enjoyed a much softer landing: they would have lost about half as much as an all-equity portfolio.

Perhaps most importantly, bonds have delivered these solid returns with a fraction of the volatility of stocks. Since 1980, the broad Canadian bond market has had just two negative years: a loss of –4.3% in 1994, and an even milder –1.1% drop in 1999.

The message here is simple: bonds should be part of just about every portfolio. While it might be reasonable for a very young investor to allocate 100% to equities, I’m not convinced that’s the best strategy. The biggest obstacle in investing is human psychology: we all hate to lose money, and a novice who experiences big losses in an all-equity portfolio in her 20s may abandon the markets altogether. Indeed, that’s exactly what seems to be happening to young people who got shredded during the last decade. USA Today recently reported that the investors most likely to avoid stocks today are Generation Y (aged 18 to 28) and Generation X (aged 29 to 45).

As an asset class, investment-grade bonds — especially government bonds — have the lowest correlation to equities, especially in Canada. (Commodities have historically had a low correlation with stocks in the US, but that’s much less true in our resource-based market.) That means they offer a tremendous diversification benefit in a portfolio, smoothing out the volatility that causes so many investors anguish. Maybe someday they’ll get the respect they deserve.