Fat Tails Everywhere? Profiling Extreme Returns: Part III

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Bonds are often the first choice for minimizing tail risk in investment portfolios, and for good reason. But this is a partial solution at best, and one that dispenses a wide range of “effective” results through time.

Nonetheless, fixed-income allocations are prized for offering ballast to equities. Most of the time this works out fine. Return correlation between stocks and bonds tends to be low or even negative, depending on the rolling window and choice of fixed-income securities. As a result, bonds tend to deliver timely diversification benefits at times of maximum stress for stocks. But nothing’s perfect on planet Earth and the limitation extends to bond allocations as a tool for managing equity risk.

The recent coronavirus correction offers a telling real-world example. Consider how a core bond investment fared during the selling wave in March. As a proxy, we’ll use Vanguard Total Bond Market Index Fund (VBMFX), which holds a mix of investment-grade securities – mostly Treasuries and high-grade corporate debt.

As a general rule, VBMFX has played a valuable diversification role relative to equities. But in the shockwave that struck markets in March, the normally defensive nature of VBMFX was subjective to severe pressure. The fund’s drawdown history this year tells the story.

In a matter of days, VBMFX went from a position of trading at a record high (March 6) to a steep drawdown of nearly 7% (March 19). For investors holding the fund and expecting a broadly diversified portfolio of “low-risk” bonds to provide a safe harbor during a financial and economic hurricane, results delivered a rude reality check.

Surprising? Not if you knew of VBMFX’s history. The fund, which launched in 1986, is no stranger to sharp drawdowns. The only aspect of the fund’s recent slide that’s unusual is the speed of the decline. Otherwise, as the table below reminds, drawdowns of roughly 4% to 8% aren’t unprecedented, based on the top-10 peak-to-trough declines for VBMFX.

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