Where to put your money in bonds? Common Sense Advice For Long-Term Investors

 

I recently interviewed Francis Kinniry a Principal in Vanguard’s Investment Strategy Group on the topic of fixed income allocation. He said that Vanguard believes that the majority of one’s returns will come from the equity side of one’s portfolio. According to Fran, the primary role of bonds is to provide diversification and protection against equity risk, rather than be a primary engine of a portfolio’s gains. I think there are two important ideas here.

  1. The performance of bonds should not be viewed in isolation, but within the context of how they change the overall characteristics of portfolio.
  2. Having bonds (or at least the right type of bonds) can lower one’s portfolio risk.

Bonds have two important characteristics that make portfolios they are included in less volatile. Bonds in general are less volatile than stocks. Inherently bonds are designed to have less upside and downside than stocks. The best scenario for a bond when held to maturity, will be to pay interest on principal on time and in full. On the other hand, a stock that performs well can double or triple in value over a short period of time. A bond by nature is a less risky and therefore less volatile instrument than a stock. If you add a less volatile investment (bonds) to a portfolio composed of more volatile investments, the overall volatility of the portfolio will go down. (you can learn more about this here)

Bonds don’t behave the same as stocks. When stocks rise, bonds will not necessarily rise in tandem. More importantly, when stocks fall bond prices don’t necessarily fall. While there is a bunch of classical economic theory which supports the idea that bond and stock prices should move in opposite directions, the real world is far more complicated. But we can say with a fair degree of certainty, that movements of stocks and bonds have little correlation.
Because of these two characteristics, bonds make a great compliment to the stocks in one’s portfolio. However, there are some types of bonds which don’t have one or both of these characteristics and in my view should not be part of a fixed income portfolio.

  • High Yield / Junk Bonds – prices are highly correlated with stocks &  volatile
  • Bank Loan Funds – prices are highly correlated with stocks & volatile
  • World Bond Funds – price not correlated with stocks but almost twice as volatile as intermediate bond funds
  • Any Fund With The Word “Long” in its name – lots of volatility due to sensitivity to interest rates

Basically, the types of funds mentioned above all contain an additional element of risk that one would not find in a core bond fund:  Junk Bond and Bank Loan funds take on additional risk by holding debt from companies that have a high probability of default. World bond funds have currency risk because they hold debt that is not denominated in US Dollars. Long Bond funds, which have bonds with average maturities more than 10 years, have potential to have massive losses if interest rates rise. By taking on these additional risks, you eliminate some of the benefits that “fixed income” provides as a hedge versus equities.

There are situations however where these types of funds might still be a good edition to a portfolio, just not as part of the traditional fixed income allocation.  The terms “bonds or fixed income” describe a type of investment product, a debt obligation. However, when used in a discussion about asset allocation, the terms refer to the qualities of the investment which most fixed income products offer; the conservative part of one’s portfolio  whose returns are not highly correlated with stocks. Under this definition, junk bonds, which have lots of volatility and whose performance tends to be more in line with stocks than treasuries, would not be considered fixed income.  They could however be considered and a nice complement to the equities side of a portfolio allocation.

 

Does having only 1 or 2 bond funds or etfs make sense?

The central question is what type of bond mutual funds funds and bond ETFs should one invest? Several people and firms which I interviewed for this article article answered, “it depends.” However, when I pressed them on what it depends on and was it possible to construct a few basic rules of thumb, they declined to give specifics. There were two exceptions, Ric Edelman of the Edelman Financial Services and Francis Kinniry of Vanguard.

Ric Edelman believes that constructing a portfolio is a highly individual process. Because of this belief, he would not suggest generalized fixed income category allocations. However, when asked what type of asset allocations within fixed income would concern him, he gave clear, specific answers:

What surprised me in his answer was his rejection of TIPS and municipal bonds. The most popular bond ETF in the world is the iShares TIP. This product is frequently used by financial advisors to protect their clients portfolios against rises in inflation. Ric Edelman’s take on TIPS was interesting. He called the product “untested” and compared to the portfolio insurance that was offered in 1980s. Since the introduction and widespread use of TIPS, Ric noted that we have never had a period of rapidly rising inflation; we have never seen how TIPS actually perform during the scenario which they are designed to provide provide protection. Other financial protects, such as portfolio insurance, that promised to insulate investors against risk did not live up to their hype.

As far as municipal bonds, we’ll get to his view later as it conflicts with the one offered by Fran Kinniry of Vanguard. However, both Ric Edelman and Fran Kinniry did agree on a central point. That investors should focus on total return (changes in price plus income), rather than yield (income) when choosing a bond fund. The expression that is frequently used to make this point is that, “You don’t eat yield, but you do eat total return.” Even if a portfolio is providing a good yield, paying good sized distributions each month, that does not mean that portfolio is not losing money. A high yield now, when obtained by increasing a portfolio’s risk, can lead to a much lower income later.  For example, Greek bonds were paying yields of 20% for a short-time, but investors ended up suffering a 50% loss of the the bond’s value.

 

Vanguard Suggests That You Have A Well Diversified, Investment Grade US Bond Fund

Earlier in this article, we mentioned the importance of bonds in terms of lowering a portfolio’s volatility. We just discussed that investors should focus on total return rather than yield. Can one fund or type of fund provide a solution? Francis Kinniry suggested that one fund could in fact be the only bond holding an investor needs. As long as that fund mirrored the entire US investment grade bond market, it could be the only bond investment one needed.

The US investment grade taxable bond market is really composed of three sizable parts:

  1. US treasury bonds
  2. Mortgage Backed  Securities (mainly backed by US government)
  3. Corporate Bonds.

In other words, when you buy a fund which tracks the US investment grade bond market,  two-thirds of it could be considered US federal government debt. When you buy a broad US investment grade bond fund, there is minimal “credit risk”.

The average maturity of a broad bond index is around 5 to 7 years.  Investing in an index with lower maturity would provide less volatility. However, shorter maturity bond funds, historically provide much lower total returns. In terms of maturity, broad indexes provide a nice balance between risk and total return.

What mutual funds and ETFs provide access to the broad US investment grade bond market? My first choice would be the Vanguard Total Bond Market ETF (BND). With an annual expense ratio of 0.1% its hard to beat.

 

How about municipal bonds?

I personally know two really smart rich people that have most of their wealth invested in municipal bonds. I asked both Fran Kinniry and Ric Edelman their thoughts about a 100% municipal bond portfolio. I expected both to say that while municipal bonds were a good investment that tying up a 100% of one portfolios was a bad idea. Neither provide the expected response.

Fran Kinniry called this idea “acceptable if not prudent” for taxable assets (not in an IRA, 401k, variable annuity) for those in a top tax bracket. The individual financial situation and goals of the investor would determine if this type of asset allocation make sense, however, he indicated that it did for many wealthy investors.

He noted that investment grade municipal bonds were extremely safe. Not only were they highly rated in general, but the default rates for municipal bonds were much lower than similarly rated corporate bonds. Fran did emphasize the need for diversification if one did go with this approach. While rare, defaults do happen. However diversifying among thousands of issues and issuers would minimize the risk.

Ric Edelman did not share this point of view. His view was that municipal bonds were much riskier than commonly thought. He focused on two risks: 1) Default Risk and 2) Political Risk. 1) Ric believe  that the financial problems of municipalities were far greater than commonly thought. In particular, he mentioned pension liabilities for retiring workers were a major danger. 2) Ric was also concerned with potential changes to the federal tax code. With the federal government running large deficits, he thought that changing the tax treatment of municipal bonds was within the realm of possibility. If preferential tax treatment of municipal bonds was eliminated, Ric predicted that the bonds would lose 30% of their value overnight. Given these risks, Ric did not think the small  additional after-tax yield offered by municipal bonds balanced out the level of risk.

 

Where do I fall?

Somewhere in the middle. I think Ric raises good points but municipal bonds have an amazing track record for over 70 years of providing total returns that are higher than other types of bonds, through multiple financial crises. I would not recommend a 100% municipal bond portfolio, but I would be comfortable with 30% of an overall portfolio being invested in them.

Print Friendly

Get Free Market Updates

Related posts:

                          

Leave a Reply

Your email address will not be published. Required fields are marked *