Central banks jumped into action in March 2020 as Novel Coronavirus worries continued to batter markets, with the Fed cutting interest rates 0.50% and the ECB and Bank of England expected to follow. This action was meant to stimulate financial activity by making borrowing cheaper. Economists wonder how effective further rate cuts will be to boost the economy against a health epidemic.
One thing is clear: investors that held bonds before the market drop saw significant price increases, as bonds became a safe haven for investors fleeing stocks. That means portfolios with losses from stocks were somewhat offset by bond price gains and, consequently, enjoyed lower overall portfolio volatility.
Below briefly explains how bonds, or fixed income assets, work to reduce overall portfolio volatility.
Fixed income is effectively a loan from an investor to a company, called an issuer, for a specific amount. The investor receives fixed payments to a fixed schedule from the issuer until the loan principal is due back to from the issuer to the investor. Fixed income investments are generally quoted with their yield: the annual interest payments or cash flow received divided by the market price of the bond.
Bond Yield = Annual Cash Flows ÷ Bond Price
When speculative investors think (not know for sure, by the way) that there will be future economic instability due to external events, they tend to buy more fixed income, particularly government bonds, which are perceived to be safer. That pushes bond prices up and the yield down, based on the above yield equation.
When a portfolio has both stocks and bonds in these times of great economic uncertainty, the losses in stock positions are often muted by the gains in the bond portfolio. This is why a diversified portfolio demonstrates less volatility (value changes) than a portfolio that holds only one asset class.
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