Asset Allocation, Bonds, and Interest Risk

[Belial]

Greetings MMM community,

I come seeking wisdom regarding place of bonds in today's asset allocation.  I set up a Vanguard account last September and invested in what I thought was a pretty conservative 50/50 mix of US stock and bonds (The total funds, VBTLX & VTSAX).  The stock fund has done quite well, it's up about 15%.  The bond fund however, did much worse, increasing in value only about .01% in the same time, less than the interest rate on my savings account. 

At first I found that a bit disappointing; but you diversify to reduce risk, right?  Then, more recently, I started reading about the interest rate risk of bond funds.  That made me wonder, why am I putting this money at risk for such a low return rate?

I'd like to use a nice simple 3 portfolio strategy, but I'm concerned that the return of bond funds isn't worth the risk right now when looked at in isolation.  I'm also concerned that the high price and low yields of bonds mean that they aren't as good of a hedge for stocks in today's conditions as they were historically. 

Are these valid concerns?  If so, is there another investment vehicle that I can use to replace bonds?

Or should I just shrink the bond allocation?  Would something like 10% Bonds, 60% US stocks, 30% International Stocks work?

[Joet]

The role of bonds isn't purely for yield in your portfolio, it is to reduce risk and volatility. How do we know interest rates 'must' rise? We could be looking at a Japan scenario for 30 years. Or longer. Perhaps after that 30 year period it does finally rise "as everyone knows it must". What good did it do you to tilt the volatility/risk profile of your portfolio towards equities?

To counter some of the interest rate risk, consider I-bonds and EE-bonds [zero principal risk], and perhaps intermediate term bonds (~6 years max) only. The "risk" to a rising rate scenario where you hold the bond fund/ETF to the median duration is practically zero. AKA the fund re-purchases new, better yielding bonds all the time, and the old ones [which are marked down due to the rising interest rate] finally come due and are paid off at the note rate. If you backtest various recession scenarios, the risk to bonds in a rising interest rate environment is often drastically overstated. I would caution you to avoid the longer term bonds, though. One exception might be individual issue 30-yr TIPs, held to duration directly from the ustreas site.

[smedleyb]

Here is an excellent interview with bond guru Jeff Gundlach who espouses a more bullish stance toward bonds:

“Quantitatve easing is NOT going away. Every major country is running a deficit. If they are all net borrowers then who is the lender? The central banks.   For this reason – QE is not going away for a long time...Should you own bonds? In such an environment as currently exists, and will likely continue to exist, bonds are absolutely appropriate in a portfolio. Yields will be lower in the future – not higher."

http://www.streettalklive.com/daily-x-change/1689-jeff-gundlach-why-own-bonds-at-all.html

[matchewed]

Belial,

You may need some more education in investing generally. 50/50 is extremely conservative. If you happen to be young or have a long enough timeline I would be aggressively in total market (VTSAX). Then do some research, look through these boards for recommendations on books to read. Read those books because people are going to be throwing you a ton of advice but you should have the education to understand it.

[KingCoin]

You may need some more education in investing generally. 50/50 is extremely conservative. If you happen to be young or have a long enough timeline I would be aggressively in total market (VTSAX). Then do some research, look through these boards for recommendations on books to read. Read those books because people are going to be throwing you a ton of advice but you should have the education to understand it.

This is the key. If you have a long investment horizon, a 50/50 mix is very conservative.

We can wax philosophical about bonds yields all day, pitting one expert against another, but the truth is, the return profile has become very skewed to the downside. Even if, as the bond optimists suggest, we look like Japan for the next 20 years, bond returns will still only be in the low single digits (under 4% over that period). A couple percent return might end up looking pretty decent in a deflationary environment with a long-term sinking stock market, and it's reason enough to have some allocation to bonds, but when stock dividend yield matches or even exceed bond yields, you have to be mighty long term bearish to be anywhere near 50% bond allocation. I almost look at bonds as a quasi-cash that can be used as dry powder to scoop up more stocks if things go south.

Sadly, there aren't many substitutes for bonds. You could consider a 10-20% allocation to REITs if you'd like to add a little asset class diversity. You'll get yields that exceed those of bonds with some inflation protection on top. They do have downside market risks that mirror those of stocks that you should be aware of.

[tomsang]

Belial,

You may need some more education in investing generally. 50/50 is extremely conservative.

I would classify him very aggressive.  In the good ole days you could get 6%-12% and sit back and relax.  When the US Treasury yield is less than inflation, you are taking a huge bet/gamble that inflation is going to drop in the near future.  As the government pumps money it become very difficult for companies to not make lots of money, therefore there is a rush to buy equities.  Having less than 100% in equity seems risky, when the US government is doing everything they can to expand the economy.  Don't fight the wave.  Enjoy the ride.  As companies and people make money hand over fist, then the taxes go up and we balance our budget.  Of course, we do so with inflation. 

[matchewed]

You are right in light of current events. But we're talking asset allocations where you go by historical returns and historically bonds are a lower return but safer.

[Belial]

I'm sorry, I should have explained why my mix was so conservative.  A portion of this money is intended to be used for a down payment for a house in the near future.  That's why I'm concerned about interest rates rising.  It would be a double whammy - reduce the value of my bond fund and increase the price I would pay for a house. 

I'm planning on removing the money I want for a down payment and re-balancing the remainder for a longer term investment.  I'd prefer to keep it simple and just use Vanguard funds so that I can use an automatic investment.  My original plan was a three fund (domestic stock, international stock, bonds) portfolio.

But given the current environment, with bond yields so low and the interest risk, is it worthwhile to include bonds at all? It seems like bond prices are too high to rise if stocks plunge.  I was considering using REITs, bond ladders, or the Lending Club, but I dislike the extra complexity and work. 

Which leaves me wondering if I should just leave whatever I would have allocated to bonds in a savings account.  Or just take Tomsang's advice, put it all in the market, and enjoy the ride while lasts.

[Joet]

I will have to say anyone suggesting "100% equity" or thereabouts and then justifying it with macro/policy/etc statements are really just ignoring the true risk of their AA plan and are doing more than a little performance/rear-window chasing. Hope it works out for you guys though but anything over about 75% equities is beyond what any risk-averse investor should be after--such as someone in ERE. Even that is a bit high, imo. Justifying it via notions of yield/inflation/policy/federal reserve headwinds/etc is really just noise. Fixed income/bonds are about far more than simple yield.

[daverobev]

How far away are you from the house purchase? If less than 5 years, then the highest rate savings account is certainly the best place, IMHO. You won't lose too much to inflation, not over those timescales.

[the fixer]

Bond yields are pretty bad right now, and in fact CDs have had higher yield for a little while now. http://thefinancebuff.com/why-investors-dont-realize-cds-are-a-better-deal-than-bonds.html

[Belial]

Joet,

What else do bonds provide besides yield that I should prioritize them over other fixed income products (CDs / Savings Account) with roughly the same yield, but without the interest risk?

My understanding is that traditionally bonds would rise when stocks declined, so that they provided not just diversification, but a hedge against a decline in the stock market.  Do I understand that correctly?

Given how low yields / interest rates are now, It doesn't look like there is room for bond prices to rise.

To be clear, I was intending to replace what I would allocated to bonds to a non-stock asset, I'm trying to decide if it makes sense to replace bonds with another investment vehicle or if I just leave it in the piggy bank. 

And thanks for all the advice.

[Mr Mark]

Don't over react.  Diversification away from 100% equities does lower volatility somewhat. And short to medium term bonds from the U.S. treasury will never fall too much as you can hold them to term and get 100% back nominal.

Go to Vanguard and compare 10 year returns of a balanced bond/stock fund like VWINX vs the SP 500. The reduced volatility may help you sustain an asset allocation even when things get crazy.

Moderation in all things. Have some REITs, some real estate, some overseas stuff. I even have a forest growing away, ready to be harvested in around 2024.

While I agree bonds are near a megacycle high, it could go a bit higher. So I stick to my 15/85% AA, and focus on saving and income. And, as I've said, if you are that worried about all this FED and macro fear mongering, get yourself a 30 yr fixed rate mortgage with 20% deposit.

[kyleaaa]

Bonds are not risky. The absolute WORST CASE scenario for the bond fund you own is maybe a 10% drop over a period of 3 or 4 years. Contrast that with what happened to stocks in 2000 and 2008. Bonds are not risky.

If you're really worried about it, switch to shorter-term bonds or even CDs.

[DryIceZ33]

How are you calculating the worst case return of -10% of VBLTX on an interest rate rise over the next 4-5 years?

It seems like with an average maturity of 20+ years, this fund would drop at least 20% per each 1% rise in interest rate?

Bonds are not risky. The absolute WORST CASE scenario for the bond fund you own is maybe a 10% drop over a period of 3 or 4 years.

Looking at the worst 3 months in google, the drop was -9.88% - pretty steep....

https://www.google.com/finance?q=MUTF:VBLTX

[Joet]

I'm pretty sure most everyone is sufficiently scared of holding longterm bond fund/indexes/ETFs at this point [and rightfully], but the intermediate term ones [BND, BIV, etc] are not very scary at all with their median duration of ~4-6 years. If you can hold it at least that long, you are going to be fine.

I don't mean to say that the equities/fixed income necessarily means that "fixed income = bonds" either. As stated earlier it looks like certain [callable?] CDs are probably presenting the best risk-free return or perhaps even a HY checking, or I/EE savings bonds, or P2P lending... or who knows..

As stated earlier, the point is that during the next recession, you can look at your ~25% or so pile of stable non-equities, and feel somewhat happy with your choice and not do anything drastic. For those who have already gone through various black monday/dot.bomb/great recession events with a certain AA before, you already know what you will do most likely and can consider yourself somewhat battle tested. But everyone has a limit. aka 'everyone has a plan until they get hit in the mouth'

I DO however think its fine to hold an individual EE bond [~eq to a 20-yr bond] or an individual 30-yr TIP. Just be prepared to hold to maturity :)

[Joet]

also past-performance/backtesting has no bearing whatsoever with future returns

bonds/fixed income could outperform equities for the next 50 years, nobody knows

[Kriegsspiel]

On a personal note: I am highly risk tolerant. I was comfortable with 100% equity and I am not the type to panic sell. Rather, I buy during dips. Even so, I am now at 40% bond, 60% stock asset allocation. Why? Because the risk adjusted return is better: I have a better chance of making good money with that allocation than I do making "big money" with a 100% equity allocation. There is an excellent article on this here:

http://www.norstad.org/finance/risk-and-time.html

Read that article a few times. It's worth letting percolate. The take-away message for me was, even if you're "the perfect investor" whose contrarian views and actions have you buying during dips, selling at peaks and with a diverse 100% equity portfolio, your end result at retirement may still be poorer than if you'd held some bonds or other asset classes that would have reduced the standard deviation of your entire portfolio.

Interesting article, there's a discussion over at Bogleheads started by Ryan Melvey about this topic also.

[Belial]

THAT is exactly why I hedge my portfolio using bonds.

Do you believe that bonds really a hedge (against stock losses) or are they merely diversification? 

http://www.riskglossary.com/articles/hedging_and_diversification.htm

Or to put it another way, are bonds and stock still negatively correlated?   If so, hedging using bonds still offers and upside, despite low yields.  If not, I think I want to look at other asset classes that will still give me diversification, but offer better returns. 

I definitely still have a lot to research, but I think I've narrowed the topic.

Today’s bond yields are so low, they could double and still be in the lowest decile of their long term history. Stocks actually have positive correlations when yields are low, and the correlations don’t turn negative until yields rise to around 6%.

source:  http://lwcm.com/research/stock-bond-correlations-are-upside-down


OTOH: http://www.priceactionlab.com/Blog/2013/04/anti-correlation-between-stocks-and-bonds-is-still-high/

[Joet]

not sure if this was posted already: salient article from vanguard on whether or not to reduce bond allocation now: CN: nope


https://personal.vanguard.com/pdf/s704.pdf

[the fixer]

That Vanguard paper gives very good advice for investors pondering dividend stocks, REITs, etc. as a substitute to bonds, but they don't mention CDs or I bonds at all. These papers are directed at least partially at institutional investors, who can't see the same benefits us little guys can from these instruments.

[Belial]

Very interesting paper.  I would like to see figure 1 [Median monthly asset-class returns during periods of bottom-decile returns for U.S. equities, 1988–2012] adjusted for only when interest rates were this low. 

While I can certainly understand those who don't wish to change their investment strategy according to oft-changing macro market conditions, I really do thing the current economic climate is sufficiently different that it warrants re-examining our assumptions. 

I'm quite curious how much evidence there is the quote I included earlier about stocks and bonds being positively correlated (they will move in the same direction) when yields are under 6%.  Always more to research...

[Joet]

there's nothing really to 'research' regarding backtesting, IMHO.

We have no idea which asset class will lead over the next 10,20, or 30 years. It could be bonds, tulips, real estate, gold, or chicken wings :)

[michael]

We have no idea which asset class will lead over the next 10,20, or 30 years. It could be bonds, tulips, real estate, gold, or chicken wings :)

Could definitely be chicken wings if they get genetically engineered out in favor of big breasts!

[KingCoin]

I didn't find that the Vanguard study made much of a case for bonds. Basically, they argued that bonds are less useful as a portfolio hedge than they have been in the past, but they offer some protection in an equity sell-off (um, duh). But shouldn't it follow that if bonds provide more downside protection in some yield regimes than others, that it makes sense to hold more bonds in those periods?

I suppose you could make an argument that in low yield environments, equity sell-offs are more probable, and therefore while bonds provide less absolute return, they make up for it on a scenario weighted probability basis. I suspect that this would be a hard case to prove.

Would they have made the same argument if bonds were yielding 1% instead of 2%? How about at 0.25%? At some point the convexity profile of cash becomes much more compelling than that of bonds. It would have been interesting to compare cash as a portfolio instrument in place of bonds in a variety of going-forward macro scenarios.

[the fixer]

Would they have made the same argument if bonds were yielding 1% instead of 2%? How about at 0.25%? At some point the convexity profile of cash becomes much more compelling than that of bonds. It would have been interesting to compare cash as a portfolio instrument in place of bonds in a variety of going-forward macro scenarios.

From the perspective of an institutional investor, "cash" means a money market account. Those things have NO yield right now, and some risk in a major financial collapse.

Yes, for you and me cash has some good things going for it, but not for one of Vanguard's major audiences.

[rjack]

I currently have my entire bond allocation in short-term corporate bonds. This reduces the interest rate risk (which I think is high) at the expense of credit risk (which I think is relatively low).