I am constantly disappointed to see all the investment columnists and financial magazines that continue to urge investors to allocate a permanent portion of their portfolio to bonds, especially Treasuries and investment grade corporates, as a way to add "balance" or "stability." Sites aimed at retirees and investors anticipating retirement especially disturb me because they convey the impression that you are making your portfolio safer and more conservative by shifting the allocation from equity to bonds as you get older, when in fact you are merely increasing the likelihood that you will (1) come up short in terms of income to live on, and (2) incur capital losses when interest rates eventually rise.
Automatically allocating part of your portfolio to bonds made sense thirty years ago, when interest rates were at record highs (my first 30-year mortgage in 1980 was at 15 ¼%), and continued to make sense for years thereafter as rates slowly dropped but still offered reasonable yields (6-8% or so). But with interest rates at record lows, all that Treasury bonds (less than 2%) and investment grade corporate bonds (3-4%) do for your portfolio is to lock in a substandard yield for years to come, or a capital loss if rates rise and you decide to sell, hardly the sort of balance or stability that a long-term investor should be seeking.
The idea of a "balanced portfolio" - stocks and bonds - has become a sort of mindless mantra on many investment sites and in countless articles by professional investment columnists and advisors. It has become enshrined in investment vehicles, like "balanced" mutual funds, the oldest of which - Vanguard's Wellington Fund (65% stocks/35% bonds) - has been around since the late 1920s. (Wellington is a fine fund, and I've owned it off and on for decades, but it would be even more attractive currently without its 35% bond portfolio.) And it isn't just retail investors that are trapped in this balanced portfolio time warp. Many professional pension consultants and portfolio managers cling to asset allocation strategies that were developed decades ago, and which automatically allocate a big portion of the portfolio to "fixed assets," meaning bonds.
Like many ideas that made sense once, but gradually lose their relevance as conditions change, this one needs to be re-evaluated. The idea behind a balanced portfolio is the trade-off between a potentially higher but less predictable return (e.g. a potential equity return in the teens) and a more modest but predictable return (say 6 or 7% on a bond portfolio.) What made the trade-off reasonable (in the past) was the fact that the modest return on the bond portfolio was still "acceptable" - not great, but OK. An investor might rationally decide to give up the wide range of possible returns on a portion of their equity portfolio in order to make a nice predictable 6-7% cash return on their bond portfolio. But even that bond return wasn't assured, since interest rates could move - up or down - and take the market value of the bonds with them, albeit in the opposite direction.
But that built-in bet that interest rates would drop, which is part of every fixed-rate bond, has paid off handsomely over the past thirty years, as interest rates have made a long-term secular drop from the high teens to almost zero. So long-term bond investors - whether they held for 30 years or just got in for part of the ride - have made equity-like returns in their bond portfolios when they add the capital gains from the interest rate decline to their cash coupons.
But does anyone really believe today that interest rates are more likely to fall from current levels than they are to rise? That's the bet you are making when you buy a fixed rate bond. So unless you believe rates are likely to move down as opposed to up over the next 10 years, then you shouldn't be buying bonds. (Exception: If you're buying bonds because you think the economy will implode and rates may go even lower, for a while, then buying bonds as a speculation - a bet against short-term economic growth - is rational. But then you're a trader, not an investor, and not the audience I'm writing for.)
So what's a conservative investor to do? Many investing sites still pitch the idea that bonds are a necessary anchor to a portfolio, and that as people approach retirement, they should increase the relative size of that anchor. Unfortunately, I don't know any retirees, looking at the next 10, 20 years or more during which they plan to live off their investments, who want to see their returns "anchored" to yields of 2 or 3%.
Instead, a truly conservative investor will say, "What can I invest in that will (1) provide me a solid, predictable stream of income, and (2) also protect me against inflation robbing me of the purchasing power of that income stream?" Obviously, if you have read this far, you know that fixed-rate "bonds" is not the correct answer to either of those questions. But what is?
The answer, I believe, is a diversified assortment of investments that will (1) provide a predictable level of income that is sufficient to live on, and (2) that has some growth potential to increase over time to offset inflation. Components of the mix will be:
- Classic "dividend growth" stocks, of which there are dozens to choose from, like Johnson & Johnson (JNJ), Chevron (CVX), Spectra Energy (SE), Royal Dutch Shell (RDS.B), Conoco Phillips (COP), H.J. Heinz (HNZ), Intel (INTC)
- Utilities, Infrastructure and Real Estate stocks, which have fixed-income characteristics in terms of the steadiness of their dividends (especially in a diversified portfolio), but also have some modest growth potential over time; e.g. Southern Co. (SO), National Grid (NGG), PPL Corp. (PPL), Duke Energy (DUK), Dominion Resources (D), Pembina Pipeline (PBA), AT&T (T), Verizon (VZ), Kinder Morgan Inc. (KMI), Realty Income (O), Health Care REIT (HCN)
- Closed end funds and other mutual funds that hold diversified portfolios of the above types of investments. (Closed end funds are a favorite holding of mine, because they allow retail investors to take advantage of currently cheap interest rates via the portfolio leverage that many closed end fund managements take advantage of.):
- Closed end funds: Reaves Utility Income Fund (UTG), Cohen & Steers Infrastructure Fund (UTF), Duff & Phelps Global Utility Income Fund (DPG)
- Open end funds: American Century Utilities Fund (BULIX), Fidelity Telecom & Utilities (FIUIX)
- Floating rate loan funds; these funds hold corporate debt obligations, but unlike bonds that are fixed rate and drop in value when interest rates rise, the loan interest coupon increases as rates rise, so loans serve as a portfolio hedge against rising interest rates. Some favorites: Nuveen Credit Strategies Income Fund (JQC), Eaton Vance Senior Income Trust (EVF), Black Rock Floating rate Strategy (FRA)
How about safety and stability? I would argue a portfolio like this is more stable and less risky than the traditional portfolio recommended for someone approaching retirement that would typically have 40% or 50% (or even more) in bonds. Both portfolios carry a risk of market value depreciation: (1) the traditional "balanced" portfolio will lose value if interest rates rise, stocks drop, or both, and in all three cases, it sacrifices income because of its low-yielding bonds; (2) my income-focused portfolio will also drop in value when stocks drop, but it will generate a higher income to the investor while he/she waits for stock values to rise again.
As retirees or potential retirees, investors have to ask ourselves, what is most important to me: generating the highest income, now and in the future, for myself, or protecting my principal value, irrespective of whether it is generating an optimal income stream or not? For me the answer is easy: I try to maximize the cash flow over time, and trust that the market value will take care of itself. In today's environment, that means staying away from bonds, regardless of how well they've treated me over the past thirty years.