Switching Out of Bonds Isn't the Answer. Or Is it?

Christine Benz, Morningstar's director of personal finance, has written an article on the dilemma that faces bond investors today. The dilemma is the combination of historically low rates (present)and the threat of inflation (future). That formula is deadly for protection of principal. Her article is instructive for the purpose of seeing what knots we can tie ourselves in if we are not clear about what we are saying to our audience in this area. But it still manages to contain some good advice. It reads (in part):

Whether your guru is Jack Bogle, Bill Gross, or Roger Ibbotson, the smart money is on bonds posting disappointing returns during the next decade.

The logic is certainly sound. Bond returns are composed of two elements: whatever income they pay out and any price changes in the bonds themselves. And on both counts, the situation for bonds looks bleak. Current yields, historically a good proxy for bond returns in the future, remain ultra-low--about 1%-2% for shorter-term bonds and 3%-4% for intermediate-term bonds. And should interest rates head higher--and they really have only one way to go, following generally declining rates for more than two decades--prospects for declining bond prices are very real.

Given that dour outlook, it's tempting to downplay bonds as a portion of your portfolio. Some investors have suggested that you might as well hunker down in cash until worries about rates blow over. You'll have to settle for lower yields, but at least you won't face the principal losses you might confront in bonds.

Alternatively, if market watchers are right that bonds are in for a depressing decade, all the money we might see come sloshing out of bonds would have to go somewhere. From that standpoint, it might seem compelling to swap at least some of your fixed-income stake for stocks.

Mark here. We have ALREADY seen a mass exodus by retail investors from equities into bonds, bond funds and structured products. We've chronicaled that here. That flight has bid up prices to levels last seen in 2007 before the Lehman Brothers implosion. And equities have run 80% off their bear market bottom. Should we now reverse field? Benz writes that:

the bond market is a pretty efficient machine, and current bond prices factor in multitudinous bits of information about the economy and the prospect for interest rates. For you to take an antibond bet and, say, shorten up your fixed-income portfolio or move entirely to cash, you're essentially saying that you have better foresight of what bonds will do in the future compared with other market participants. You might, but you might not.

Mark again. The author appears to be saying "The market is likely smarter than you. All you are doing is guessing." Well, MAYBE. In Spring of 2000 with the market at 1550 plus on the SP500, did the market "have it right"? How about in Fall of 2007 at about the same levels? Good lord I had hoped that this canard that the market is some efficient discounting machine had gone the way of the dodo bird. It's a nice theory that runs aground on empirical observation. So if we don't possess The Crystal Ball we should do nothing? What we absolutely KNOW is that returns from bonds will be LOW. That's a given. Sure they could move lower. But that would be a temporary capital gain and likely quickly given back. If it is not that signals BIG TROUBLE for the economy and bonds returns will be your least worry.

And while it's hard to get excited about investing in an asset class with the threat of losses looming over it, it's also worthwhile to consider the likelihood and magnitude of losses one might face in bonds, especially if you have a time horizon of a few years or more. (If your time horizon for your money is shorter than that, you belong in cash.)

The Barclays Capital U.S. Aggregate Bond Index, a broad index tracking much of the domestic fixed-income market, hasn't posted a loss in any rolling three-year period since 1983. Granted, that was a very favorable period for bonds, marked by generally declining interest rates. But even an examination of a less forgiving bond-market environment shows that the threat of rising interest rates shouldn't prompt a wholesale panic.

A recent Fidelity study, looking back to the period of 1941-81, when yields rose from 0.5% to 16%, showed that investors in intermediate-term Treasury bonds actually lost money in just 1% of the rolling three-year periods during those 40 years. Yes, rising rates depressed bond prices during that period, but the higher yields that investors were able to pick up offset the price declines in most cases. Due to the ability to earn higher yields, intermediate-term Treasury investors actually made money during that inhospitable 40-year stretch. They averaged a 3.3% annualized gain during that period, well below bonds' average gains of 5.3% since 1926, but a positive gain all the same.

Additionally, the magnitude of losses that one might expect from bonds, even in a tough interest-rate environment, is also apt to be a lot lower than what you'd see from stocks. To use a recent example, long-term government bond funds, which tend to be extremely sensitive to changes in interest rates, lost 9% in 2009 amid concerns that rates would trend higher. Such a loss is never welcome, to be sure, but it pales in comparison to the 37% loss that S&P 500 investors faced in 2008.

Hmm. Are we saying invest because your losses, if any, are likely to be small as well as any gains, that is, over 40 years you see, so the whole thing would be "No Harm No Foul" if you do? And by the way, were those paltry returns real or nominal? I guess she is saying what I said above: Bonds could be the least of your worries. Let's move on.

What to Do?
Even though the prospect of rising rates shouldn't dictate a wholesale revision of your asset allocation, there are still steps to take to protect yourself.

For starters, consider downplaying long-term bonds as part of your portfolio, as Jack Bogle suggests in this video (Ed: Morningstar video link ommitted). Yes, long-term bonds have gained about a percentage point per year, which is more than intermediate-term bonds, on average, during the past decade, but their volatility as measured by standard deviation has been almost twice as high.

Second, consider delegating a big chunk of your portfolio's fixed-income position to a core fund whose manager isn't shy about factoring in the interest-rate environment into his or her outlook. A few that Morningstar analysts like include Metropolitan West Total Return (MWTRX), Harbor Bond (HABDX), and Dodge & Cox Income (DODIX).

Finally, if you're holding money you truly can't afford to lose, stick with true cash rather than short-term bonds or much higher-yielding (and higher-risk) substitutes such as bank-loan funds. Yes, yields on certificates of deposit and money market funds are low right now, but you're looking to this sleeve of your portfolio for stability rather than big return potential.

Okay, finally we get to the meat of the article. After much chasing of our tails while setting up the problem, we see she recommends a few bond funds that will do the heavy thinking and lifting for you. I have NO quibbles with the three she recommends. They are well managed and have good histories. If you want a bond fund or two in your portfolio you could do A LOT worse.

But do investors have to own funds that invest only in bonds for their income portfolios? Let's say you take the route of adding some equity exposure to your income portfolio. Where are those that will buy income generating equities (REITs, utilities, MLPs) as an example? Where is Berwyn Income Fund, which buys dividend stocks in up to 30% of its portfolio, (BERIX) in her list? Have you seen those 10 year returns? Or those that hedge the interest rate risk by alternative means? Have you heard of Hussman Strategic Total Return (HSTRX)? What about THOSE returns life of fund? Must an income investor eschew ALL volatility in this part of the portfolio (if they even still divide it up into the old bond/equity buckets)in order to get to their goal (the promised land)?

Giving it the benefit of the doubt, the article tries to be a balanced look at this difficult topic. It ends up I think falling short of where it needs to go. (I wanted to write "a bit of a hash" here but thought that a wee bit harsh.) It's difficult to give advice about bonds these days. It truly is. Deflationary pressures abound in the short term. Those auger for low rates for some time. The money sloshing around out there to fix our problems says the future holds just the opposite. That at some time inflation must return. Just not now.

The author's advice is to pick a manager who has shown flexibility in the past. Can't quibble with that. Which managers have protected principal through difficult environments? That says a long history here may be needed. Or was succesful navigation of the latest low interest rate period enough? The manager likely had to skillfully manage some additional risk in order to get ANY kind of returns.

Don't limit yourself to traditional bond funds or managers. Perhaps it's not a bond fund you need at all. Look around. I bet you can come up with some better alternatives than even I have. Write me if you do. And thanks Christine for letting me ask some hard questions around your article.

Good luck. It's a tough bond environment out there.