Capitalism Stock Certificate 2011

Bond Funds: Doing Their Job

Capitalism Stock Certificate 2011

In the second quarter of 2013, IFA's recommended fixed income portfolio turned in a slight loss, which has occurred in about 15% of 604 monthly rolling 3-month periods over the last 50 years. The four high-quality/short-term fixed income funds that IFA has advised clients to invest in since 2000, had a total loss of 0.94% on a year-to-date basis as of the market close on 6/30/2013, which turned one dollar into about 99 cents, net of fund and advisory fees. A loss in monthly rolling 6-month periods has occurred in about 11% of the 601 periods in the last 50 years.

It could have been worse had you owned the famous PIMCO Total Return Fund (PTTRX), which has lost 3.02% over the first half of 2013 (source: morningstar.com). It turns out that this fund had negative alpha for 11 of the last 25 years, as seen in the chart below.

 

Since bond yields have been low relative to their historical averages, investors who currently hold a balanced portfolio may be tempted to reach for yield, which IFA would advise against. IFA reminds investors that there simply is no such thing as higher expected return that is not accompanied by higher risk and all investors should have a risk budget for their total portfolio. In past articles, we have explored some of the different ways that investors reach for yield such as high-dividend stocks, preferred stocks, junk bonds, and mortgage REITs. We found all of them to be problematic.

A recent article from Vanguard Research, Reducing Bonds: Proceed with Caution, shows why balanced investors are better off holding on to their bonds. The essential argument is that even though bond yields have been low, bonds still remain a good risk reducer for equities in your balanced portfolio due to their low standard deviation and their low correlation with equities. Bonds also provide and investment vehicle to fund your liquidity needs, or expenses, over the next 3 to 5 years. For high-quality/short-term bonds, IFA has measured the correlation with equities at essentially zero, which means that the returns of these two asset classes in a given time period move independently of each other.  This implies that even if equities have experienced a substantial drop, the most likely outcome for bonds is that they would have earned a positive return.

To see how this might work in practice, let’s suppose that equities experience a 20% drop in a given year while bonds deliver a return of only 1%. For 60% equity/40% fixed income investors, the total drop in their portfolio would have been 11.6%. If, however, the bonds had returned 5%, the total drop would have been 10%. Hopefully, a loss in this range would be tolerable for our hypothetical balanced investors, and they would rebalance by selling bonds and buying stocks. If equities subsequently rebounded, they would own more shares on the upside than they had on the downside, enhancing their overall return by about 1%. If, instead of owning high-quality/short-term bonds, they owned an asset class that has a higher correlation with equities such as junk bonds, they would not have received as much of a benefit from rebalancing.

One common and incorrect argument against the inclusion of bonds in a portfolio is often heard from active investors who forecast that interest rates are likely to increase and therefore bond prices will be clobbered as a result. First of all, there is no reliable way to forecast interest rates. Secondly, for holders of short-term bonds, like IFA's advice, an increase in interest rates is acceptable because the constant cycle of maturing bonds in a fund will be reinvested at the forecasted higher interest rates, if they even occur. While interest rates follow a random walk and are unpredictable, we were able to examine four different historical periods of interest rates changes (based on the Federal Funds Rate) to see what happened to the mix of bonds used in the IFA Index Portfolios (IFA Index Portfolio Fixed Income) as well as a 60/40 balanced portfolio (Index Portfolio 50). As seen in the chart below, the bond funds held their own, while the balanced portfolio delivered returns that are above the long-term (85-year) historical annualized return of 8.46% and the lowest return of 9.85% was about the same as the recent 50-year annualized return of 9.9%.

 

The other important function of high-quality/short-term bonds is to provide a vehicle for short-term liquidity needs. If investors have a sudden need for cash, they would want to avoid selling equities after they have gone down, so having the ability to sell a portion of a bond fund rather than the equities is highly beneficial in this situation.

To summarize, we wholeheartedly agree with the conclusion of the Vanguard paper cited above:

“The diversification benefits of bonds in a stock/bond portfolio will likely persist. This feature, more than projected returns, justifies a strategic allocation to bonds.”

Even though bond funds have recently provided relatively low total returns, if there is a better alternative to high-quality/short-term bond funds as the risk-reducing and liquidity-providing asset classes in a balanced portfolio, we have yet to see it.