Do you actually need bonds in a diversified portfolio?

[Matt]

Bonds are classic components of a diversified portfolio. Over time, Bonds are expected to produce less return than Stocks, and their price and yield (income) is derived from interest rates. Bonds are a hard investment to swallow right now because interest rates are very low, and expected to rise.

• Interest Rates Low= Low Yields
• Interest Rates Rise = existing bond value drops

Looking at bond funds yesterday on Vanguard the SEC yields seemed to hover around the 2% mark. Longer duration funds would pay more, and shorter less.

2% is a pretty hard number to swallow when we are told about historical levels of 6% or more. The question then arises, can you accept a 2% yield, or do you not need to?

Taking a $10K example.
Assuming broad ETF positions, If you elect a 100% stock allocation your investment will move up 10% when the market does... and also drop by 10% when it drops. You are riding the wave. In this case you'd be up to a high of $11,000, before a 10% loss and end up with $9900...

If however, you elect 70% stocks and 30% cash (zero APR), when the market goes up 10% you'd be up to $10,700, and when it drops 10% $9930.

Bonds in this environment are like cash, but pay a bit more. At 2% yields:

70% stock gain 10% lose 10% = $6930
30% bond gain 2% = $3060
total after drop would be $9990

However... if interest rates rise the price of the bond fund will drop, and it will take several years to recover.

Can both stocks and bonds drop together?
History tells us that bonds and stocks are broadly uncorrelated in movement. However, there is a correlation at this time between bonds and stocks in the sense that quantitative easing and low interest rates are fueling the stock market. The reality is that rates will rise, likely at some point during this year. When they do, that will impact bond prices.. the question is will it impact stock prices also?

Why be in bonds at all?
The examples above show that being in bonds can protect against downward movements of the stock market, in some situations. The real value though is having assets outside of the market when the market drops, and using these to buy stocks at a lower price point. This is the essence of rebalancing a portfolio.

A better question might be, why be in stocks at all? The answer tends to be because people are seeking a return that will leverage wealth to the point where they can achieve their goals. If we forget the stock market for a moment and suggest that everyone invests in long term bonds, yielding around 4% at this time, plans fall apart.
Bonds might be a bad bet with low interest rates, and the impending rate rises, but if you don't have them in your portfolio, what are you doing to stop riding the rollercoaster of the market back down?

 

[Julian Brennan]

Well the only reason for me to owning bonds or rather bond ETFs is to park funds we don't plan on needing mid term as in 2-5 years which boils down to a single goal: saving up for our next car. Their yield is a notch better than savings accounts. Monies which have a big fat "for retirement" sign on them go to stocks. The yield grows over time as the underlying companies grow their profits and payouts. Historically bond yields barely make up for inflation so you're effectively losing money by investing in bonds. For me the only way to stay ahead of money devaluation is stocks increasing their yields by a percentage greater than inflation itself. For the short/mid term this is negligible but for retirement funds which will be needed to support income 20 years down the road this is a paramount factor.

 

[henrygeorge]

I'm very inexperienced in investing.

I was intrigued in your post of Euro ETFs in multiple currencies. If the market crashed here, how much could one expect it to affect Euro markets?

 

[Hanaleiradio]

You do realize that bonds have outperformed stocks since the great Bull began in 1982?
There are better charts, but this came up quickly on google:
http://www.theglobeandmail.com/globe-investor/personal-finance/investing-calculators/portfolio-growth---historical-returns/article651822/

 

[Julian Brennan]

You do realize that bonds have outperformed stocks since the great Bull began in 1982?

Nice try ;-) I can easily "prove" the opposite result by adjusting the years on this thing a little bit. Just go a few years back, like 1979 and there you have your stocks being superior to bonds. Or you can take the 2011 back to 2008. Or ... I think you get the point of how useless this tool is.

The fact remains that bond returns are tied to the rate of interest and inflation, they will never be able to outgrow inflation in the long run. When you go back with your nice tool to say the 50s you'll see that stocks are almost 3x as good as bonds in matters of total return. That's what I call "historically" and not an arbitrary number of some 20 or 30 years.

 

[Matt]

You do realize that bonds have outperformed stocks since the great Bull began in 1982?
There are better charts, but this came up quickly on google:
http://www.theglobeandmail.com/globe-investor/personal-finance/investing-calculators/portfolio-growth---historical-returns/article651822/

That's a good average, and i'd be happy with it.

Can you tell me how I can get an average of 11.56 from bonds over the next 10 years?

 

[Matt]

I'm very inexperienced in investing.

I was intrigued in your post of Euro ETFs in multiple currencies. If the market crashed here, how much could one expect it to affect Euro markets?

Overall, the world is getting increasingly correlated. I think the key would be what caused the crash over here. Personally I can't see anything short of a war right now that would do that. Rate hikes will come, but very tentatively. They will test out the market incrementally.

I'd be worried around election time, while I don't want to get too political, I would be more inclined to see a new party in power wanting to flex its international muscles than the same one.

If there was a war, it may be more likely to have an international reach and impact and rock other markets.

 

[Matt]

we don't plan on needing mid term as in 2-5 years

Interesting perspective on the impact over time on rate increases on bond funds http://www.schwab.com/public/schwab/nn/articles/Should-You-Worry-About-Bond-Funds-if-Interest-Rates-Rise

You definitely need to have that horizon you mention, but I wonder about total return over 5 years if we have an incremental increase in interest rates during that time. I think it will still be a decent investment, but it will likely lag due to the need for the price to catch up with things.

 

[Julian Brennan]

I'm not married to my ETFs. If I can see the Fed raising rates and long term bonds fall in value I can easily disburse of them - and that is a big IF right now.

For the said mid term savings goal I have CBND and TLO yielding 3.1% and 2.5% respectively. Much better than a money market account but flexible enough to liquidate if necessary. Currently we have a very low inflation rate partly due to the collapsed oil price so I'm comfy with that yield. Nobody knows what's gonna happen a year from now or even two...

 

[Paul]

That's a good average, and i'd be happy with it.

Can you tell me how I can get an average of 11.56 from bonds over the next 10 years?

That's a disengenous time frame - we had a hist

Bonds are classic components of a diversified portfolio. Over time, Bonds are expected to produce less return than Stocks, and their price and yield (income) is derived from interest rates. Bonds are a hard investment to swallow right now because interest rates are very low, and expected to rise.

• Interest Rates Low= Low Yields
• Interest Rates Rise = existing bond value drops

Looking at bond funds yesterday on Vanguard the SEC yields seemed to hover around the 2% mark. Longer duration funds would pay more, and shorter less.

2% is a pretty hard number to swallow when we are told about historical levels of 6% or more. The question then arises, can you accept a 2% yield, or do you not need to?

Taking a $10K example.
Assuming broad ETF positions, If you elect a 100% stock allocation your investment will move up 10% when the market does... and also drop by 10% when it drops. You are riding the wave. In this case you'd be up to a high of $11,000, before a 10% loss and end up with $9900...

If however, you elect 70% stocks and 30% cash (zero APR), when the market goes up 10% you'd be up to $10,700, and when it drops 10% $9930.

Bonds in this environment are like cash, but pay a bit more. At 2% yields:

70% stock gain 10% lose 10% = $6930
30% bond gain 2% = $3060
total after drop would be $9990

However... if interest rates rise the price of the bond fund will drop, and it will take several years to recover.

Can both stocks and bonds drop together?
History tells us that bonds and stocks are broadly uncorrelated in movement. However, there is a correlation at this time between bonds and stocks in the sense that quantitative easing and low interest rates are fueling the stock market. The reality is that rates will rise, likely at some point during this year. When they do, that will impact bond prices.. the question is will it impact stock prices also?

Why be in bonds at all?
The examples above show that being in bonds can protect against downward movements of the stock market, in some situations. The real value though is having assets outside of the market when the market drops, and using these to buy stocks at a lower price point. This is the essence of rebalancing a portfolio.

A better question might be, why be in stocks at all? The answer tends to be because people are seeking a return that will leverage wealth to the point where they can achieve their goals. If we forget the stock market for a moment and suggest that everyone invests in long term bonds, yielding around 4% at this time, plans fall apart.
Bonds might be a bad bet with low interest rates, and the impending rate rises, but if you don't have them in your portfolio, what are you doing to stop riding the rollercoaster of the market back down?

Just ride it out. You don't know where to top or bottom is. And unless you really watch your investments (few do, alas), many buy high and sell low as they let emotion overcome common sense - that's why sector funds and hand holding from investment "professionals" are so popular...that few of them beat the S&P 500 (the majority don't) is rarely mentioned.

That's why you get bombarded by "scary" discussions from talking heads on CNBC and Faux Business - always some disaster coming to get worried about (inflation/deflation/war/peace/"out of control" energy prices/"collapsing" energy prices, yada yada yada yada) - anything to keep the minions buying and selling to keep the fees rolling in...

Be like Warren Buffet. He hangs on to cash for years until he sees clear buying opportunities...then invests in solid businesses, not whatever hype du jour is flogged on CNBC or Barrons...

 

[Hanaleiradio]

That's a good average, and i'd be happy with it.

Can you tell me how I can get an average of 11.56 from bonds over the next 10 years?

HaHaHa....if I could I would, my brother! Wish I could also tell you how to get the same average from stocks, or any asset class, over the same period. We'd both be fat & sassy! My only insight is that I know what I don' know.

I liked much of the post, particularly your focus on the fickleness of correlation, although I do think you come close to espousing the popular myth that in the coming years bonds have nowhere to go but down, which implies that stocks are more likely to go up, and that long term stocks always provide better returns than bonds. Those things may, or may not, be true over the next few years. The US economy, stoked by Fed stimulus, could lead the world out of the deflationary cycle that many thoughtful economist fear, in which case stocks will outperform bonds and most other asset classes (except for some commodities.) Or maybe the Fed pulls back too soon, the Chinese don't step up, the Euro austerity hawks get more restless, and the global economy falls into a long term deflationary cycle, in which case bonds would continue to outperform stocks. Or maybe its stagflation or some other form of range-bound flat-lining.

But in the short term, let me ask you this: if the Fed starts raising rates, won't the impact on stocks likely be as negative as they will be on bonds? Certainly the action of the markets in recent months would indicate so.

 

[Matt]

We'd both be fat & sassy!

I'm getting there...

Actually in terms of where the post was heading, I wanted to dive down the path of cash over bonds. These days you can get a return of about 1% from savings, and about 2% from an intermediate term bond fund. Cash offers a liquidity advantage over bonds in that raising rates will not harm its face value as it would a bond.

I do indeed think we will see some jitters in the stock market when that happens, which is why you need 'something' in terms of that uncorrelated asset.

Another path I wanted to explore (but ran out of time) was to look into the repair ratio again- IE how much of cash reserve do you need to protect $X in stocks... and therefore at what point does that need to be invested in order to stop overall drag.

 

[Free-quent Flyer]

This is what I assumed you were getting at, not a portfolio invested entirely in stocks!

I think this is basically right, in that a rise in interest rates will decrease the value of an existing position in bonds, while an economic collapse, deflation, and flight to quality would increase the value of an existing position in bonds. But that increased value could only be captured by selling and buying into stocks, something you would also be able to do with a position in cash. So while the economic collapse->sell newly valuable bond fund->buy stocks outcome would offer more upside than the cash->buy stocks outcome, it also offers more risk (of strengthening recovery and interest rate rise), and I agree that it's unclear whether that risk is straightforwardly worth taking on.

But I believe in completely passive investing in target retirement date mutual funds, so I'm certainly not the guy to ask.

I'm getting there...

Actually in terms of where the post was heading, I wanted to dive down the path of cash over bonds. These days you can get a return of about 1% from savings, and about 2% from an intermediate term bond fund. Cash offers a liquidity advantage over bonds in that raising rates will not harm its face value as it would a bond.

I do indeed think we will see some jitters in the stock market when that happens, which is why you need 'something' in terms of that uncorrelated asset.

Another path I wanted to explore (but ran out of time) was to look into the repair ratio again- IE how much of cash reserve do you need to protect $X in stocks... and therefore at what point does that need to be invested in order to stop overall drag.

 

[Hanaleiradio]

Actually in terms of where the post was heading, I wanted to dive down the path of cash over bonds. These days you can get a return of about 1% from savings, and about 2% from an intermediate term bond fund. Cash offers a liquidity advantage over bonds in that raising rates will not harm its face value as it would a bond.

Thanks for the clarification. I kind of thought that is what you were getting at, but wasn't clear.
I went 90% cash in my retirement funds a couple months ago as the increased volatility that started late last year became a regular feature. This is one of several indicators of trend "fatigue", and possible reversal. Since I'm within a few years of using those funds, preservation is overwhelming objective.

FYI-cash has good company: http://www.ocregister.com/articles/pimco-656718-erian-people.html

 

[MilesAbound]

I think the basic concept is that bonds should be less volatile (i.e. the hi/lo swings should be lower) and as such yield less than equity equivalents

One thing to note though people tend to refer to Duration as if it implied the time to maturity for a bond. This is totally incorrect. Without going into the technicalities of it Duration is a measure of how sensitive bonds are to interest rate changes. So if you want to insulate yourself from interest rate changes you should be looking for low duration bonds, which does not necessarily mean short time to maturity.

 

[Matt]

I think the basic concept is that bonds should be less volatile (i.e. the hi/lo swings should be lower) and as such yield less than equity equivalents

One thing to note though people tend to refer to Duration as if it implied the time to maturity for a bond. This is totally incorrect. Without going into the technicalities of it Duration is a measure of how sensitive bonds are to interest rate changes. So if you want to insulate yourself from interest rate changes you should be looking for low duration bonds, which does not necessarily mean short time to maturity.

Duration is very misunderstood, even in our investment class the teacher couldn't properly explain it. I think that is due to people half getting it right, but then confusing modified and macaulay's.

 

[Matt S NYC]

HaHaHa....if I could I would, my brother! Wish I could also tell you how to get the same average from stocks, or any asset class, over the same period. We'd both be fat & sassy! My only insight is that I know what I don' know.

Covered call writing against several solid long stock positions takes a decent amount of work but can help you get a good deal of upside in the equities while collecting a huge amount of option premium along the way. Done conservatively, you're talking 8-10%. Obviously you can take more aggressive positions and do better depending on your risk tolerance. 11-12% is not a crazy return for a dedicated options trader.