Saturday, June 8, 2013

What to do about bonds?

The focus of this e-mail can be summarized in one simple question: If I expect interest rates to rise, should I avoid having bond exposure in my portfolios?

Before attempting to answer this question, I will ask you another one: In terms of utilizing bonds in an investment portfolio, are we talking about avoiding bonds as our only investment asset, or are we talking about avoiding bonds as one of the asset classes in our overall asset allocation models?

I will assumes that we are addressing the latter question—that is, should an individual avoid bonds as an ingredient in a diversified portfolio? For those who invest all their money in one asset class—such as a 100% stock portfolio or a 100% bond portfolio—this is not for you.

A historical perspective

To gain historical perspective on the performance of U.S. bonds, we have to first review the history of interest rate movement in the U.S. during the past six or so decades.

Over the past 65 years (1948-2012), interest rates (the federal discount rate in this study) have risen, and then fallen. During the 34-year period from 1948 to 1981, the federal discount rate increased—not every year but as a general trend. In 1948 the federal discount rate was 1.34%, and by 1981 it was 13.42% (see Figure 1).

During this period of rising interest rates, the 34-year average annualized return for U.S. bonds was 3.83%. The year-to-year performance of U.S. bonds is represented by the vertical bars. U.S. bond performance was represented by intermediate-term U.S. government bond returns from 1948 to 1975 and the Barclay's Capital Aggregate Bond Index returns from 1976 to 2012.

As shown in Figure 1, the federal discount rate began its descent in 1982—not falling every year but generally in decline. At the end of 2012, the rate was 0.75%. During the last 31 years (1982 to 2012), the average annualized return of U.S. intermediate-term bonds has been 8.82%.

Clearly, the last three decades have provided a wonderful environment for bonds to perform well, given the overall decline in interest rates. Interestingly, U.S. stocks (S&P 500 index) performed essentially the same during both periods. From 1948 to 1981, when interest rates were rising, the S&P 500 had an annualized return of 11.00%. During the recent 31-year period of declining interest rates, the S&P 500 generated an 11.14% annualized return.

Whereas bond returns are markedly impacted by interest rate movement, stocks are largely immune—indeed, stocks march to a variety of different drummers. Furthermore, cash (as represented by the three-month T-bill) averaged 4.49% during the 34-year period of rising interest rates, and 4.72% during the 31-year period of declining interest rates.

Figure 1: Bond Performance Over the Past 65 Years
Intermediate-term U.S. government bond returns from 1948 to 1975 and the Barclays Capital Aggregate Bond Index returns from 1976 to 2012

Sources: Israelsen, with data from Ibbotson, Lipper, Morningstar, Economic Report of the President.

Bond performance in a portfolio context

Let's examine the historical performance of U.S. bonds in a variety of portfolio contexts.

A one-asset portfolio that held only U.S. bonds (U.S. intermediate government bonds from 1948 to 1975 and the aggregate bond index from 1976 to 2012) was clearly impacted by the interest rate movements during that particular period of time.

During the 34-year period of rising interest rates from 1948 to 1981, a non-diversified all-bond portfolio averaged 3.83% per year, whereas during the last 31 years, it produced an average annualized return of 8.82% (see Table 1). The difference in return for an all-bond portfolio during these two distinct time frames was a staggering 499 bps.

How about a two-asset portfolio? Let's assume the classic balanced design with a 60% allocation to stocks (S&P 500) and a 40% allocation to bonds (rebalanced annually). The differential in performance in a two-asset portfolio across the two time periods (1948-1981 and 1982-2012) is much less dramatic, though bond performance was clearly favored in the more recent 31-year time period. A 499 bps performance difference in an all-bond portfolio shrinks to a 204 bps difference in a classic 60/40 two-asset portfolio (10.56% vs. 8.52%).

A four-asset portfolio that allocated 40% to large U.S. stock, 20% to small U.S. stock, 30% to bonds, and 10% to cash (with annual rebalancing) generated an annualized return of 9.52% during the 34-year period when interest rates were rising and a 9.99% annualized return during the last 31 years in which rates were falling. The performance differential across the two time frames now shrinks to a modest 47 basis points.

Clearly, as a portfolio is more diversified, the impact of the performance of one asset class on the overall portfolio (assuming the allocations are not heavily skewed toward only one asset) is dramatically reduced. This is precisely why portfolios should be diversified—by doing so, we lower risk by not allowing the bad performance of one particular asset class to sink the portfolio's overall returns.

Table 1: Various Bond "Contexts"
Period of Rising Interest Rates
34-Year Period From 1948 to 1981
Period of Declining Interest Rates
31-Year Period From 1982 to 2012
1-asset portfolio
100% US Bonds
3.83% annualized return
4.32% standard deviation
8.82% annualized return
6.99% standard deviation
2-asset portfolio
60% Large U.S. Stock
40% Bonds
8.52% annualized return
10.49% standard deviation
10.56% annualized return
11.33% standard deviation
4-asset portfolio
40% Large U.S. stock
20% Small U.S. Stock
30% Bonds
10% Cash
9.52% annualized return
11.80% standard deviation
9.99% annualized return
10.98% standard deviation

Source: St. Louis Federal Reserve

Changing the question

My original question was, If I expect interest rates to rise, should I avoid having bond exposure in my clients' portfolios? Based on this analysis, it's clear that building a diversified four-asset portfolio over the past 65 years almost completely obliterated the impact of rising or falling interest rates on the performance of the portfolio.

Conversely, if investing only in U.S. bonds, the performance of a 100% fixed-income portfolio was highly influenced by the direction of interest rate movement.

Perhaps a more useful question at this point in time might go something like this: "If I expect interest rates to rise, how can I ideally position the bond allocations in my clients' portfolios?" That's a better question, because it doesn't put us in an asset-timing trap.

Several suggestions to that "better" bond question:

1.      Diversify your fixed-income exposure. Don't rely simply on U.S. fixed income. Look at non-U.S. bond funds in addition to U.S. bond funds.

2.      Look at cash in a new light. Money market funds will benefit from rising rates. Consider cash anew as a part of the fixed-income allocation in your client's portfolio.

3.      Choose bond funds with a shorter effective maturity. Bond funds with shorter maturity (also measured by duration) have less downside risk when interest rates rise. The trade-off is that shorter-maturity bond funds will tend to have lower returns.

For instance, Vanguard Total Bond Index (with an effective maturity of 7.1 years as of December 2012) had a five-year annualized return of 5.80% as of 12/31/12. By comparison, Vanguard Short-Term Bond Index has an effective maturity of under three years and had a five-year annualized return of 3.70% as of 12/31/12.

As always, it's a risk/return trade-off, but if you're building a diversified portfolio, you will have other asset classes that can do the heavy lifting in terms of performance. Thus, by shortening maturity/duration, you can lower risk in the fixed-income asset classes without unduly punishing the overall portfolio's performance. For more mature  clients, risk management may be more important than attempting to match the performance of popular equity benchmarks.

4.      Maintain high-quality standards. Don't over-reach for yield by using bond funds with higher allocations to low-quality bonds.
In summary, building a broad-based, diversified portfolio insulates clients (and advisors) from having to make timing-based, do-I-keep-it-or-I-dump-it asset class decisions. Diversification is a constant, not a variable. Making minor portfolio adjustments, such as shortening the maturity of the bond funds being utilized in the portfolio, is a sensible action.

Email from John Ebanietti

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