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As the bond bubble generates more and more noise, I worry that some passive investors may choose to change their asset allocation. In reality, many passive investors shouldn't worry much about the bond bubble. To show why, I offer two reasons. These reasons are by no means earth-shattering. They are simple. Despite their simplicity, many analysts overlook them--and give poor financial advice in the process. The first relates to the comparative performance of stocks and bonds. The second concerns the effect of rising interest rates on bond prices and yields.

Before examining these two reasons, I should add a few caveats:

First, no advice is suitable to every investor, and this article isn't an exception. The proper allocation to bonds in any portfolio depends on an investor's risk tolerance, tax bracket, income needs, and other factors.

Second, when discussing the past performance of bonds, I use the performance of the 10-year Treasury Bond as a proxy for bonds. I realize that this is less-than-perfect. The 10-year T-Bond has a different risk profile than many other types of bonds. It is subject to interest rate risk, but not to the extent of other, longer-duration bonds. It has minimal credit risk when compared to other bonds. For the purposes of this article, a total bond index fund would be ideal. However, few bond funds offer historical data that rivals that of T-Bonds. My choice of using 10-year T-Bonds, then, is born more out of necessity than out of desire. With that said, 10-year T-Bonds still serve as a useful touchstone. The correlation between 10-year T-Bonds and bond index funds such as Vanguard's Total Bond Market ETF (NYSEARCA:BND) is high. For a crude example of this correlation, compare the graphs of iShares Barclays 7-10 Year Treasury (NYSEARCA:IEF) and BND.

Third, I am directing this article towards investors who hold a diversified bond portfolio. Of course, investors who invest solely in long-term bonds should worry about the prospect of rising interest rates. That is not my concern. I am concerned about passive investors who hold a diversified bond portfolio. This may mean passive investors who own a single bond fund, such as Vanguard's Total Bond Market ETF. It may mean investors who own several, narrower funds, which comprise a diversified portfolio in the aggregate. It's these investors who shouldn't necessarily change their bond allocation.

Now, why should passive investors, who hold a diversified portfolio, ignore the noise surrounding the bond bubble? For two main reasons:

1. Stocks historically suffer much greater downturns than bonds

Stocks historically suffer greater drawdowns and greater volatility, on average, than bonds. From 1928 until 2012, the average annual downturn for the S&P 500 was 14.28% (see annual performance here). The average annual downturn for the 10-year T-Bond was 3.73% (see here). Yes, past performance is not indicative of future results. But this eighty-four year period includes years of rising interest rates and years of inflation, and so it offers some guidance on relative performance. Stocks don't merely suffer greater drawdowns than bonds. They also suffer higher volatility. Notice the swings between peaks and troughs, between the annual performance of the S&P 500 versus the T-Bonds--even before the early 1980's, when interest rates were increasing. Yet, analysts still advise investors to "guard" against the bond bubble by moving out of bonds and into stocks. For most investors, this is poor advice. It significantly increases the equity risk portion of the portfolio and the overall volatility of the portfolio itself. By switching out of bonds and into equity, you lose the stabilizing effect of bonds. Indeed, Vanguard made this exact point in one advisory memo. Perhaps most alarmingly, this re-allocation "fix" assumes that when interest rates rise, the stock market will also rise. This isn't necessarily true, however, as Nerd's Eye View pointed out in one post.

Is allocating out of bonds and into cash a better solution? Not really. Changing your allocation in this manner defeats the purpose of setting up a passive portfolio in the first place. Passive portfolios are meant to stop you from trying to time the market. Predicting a rise in interest rates and shifting out of bonds reintroduces market timing into your allocation strategy. This jeopardizes your portfolio's returns, by increasing your portfolio's exposure to inflation and robbing you of the benefit of compounded returns.

A wiser strategy for those truly terrified of a bond bubble is to allocate only a portion of your bond portfolio to shorter-term bonds. This minimizes interest rate risk, while allowing you to benefit from the higher yields of the longer-duration funds in the interim. Moving entirely out of a diversified bond fund like BND and into a shorter-term bond fund seems less than ideal. It robs you of the higher comparative yields that longer-duration funds offer.

2. Any drop in the price of bond funds will be partly offset by higher yields

Few analysts remember to discount the expected drop in the price of a bond fund by the corresponding increase in the fund's yield, which would accompany a rise in interest rates. Bond funds, such as BND, track the underlying index by purchasing bonds. By regularly purchasing bonds, these funds mimic the prevailing yield for bonds with similar terms. As interest rates rise, portions of the bonds that these funds hold may fall in value. This should exert downward pressure on the price of the fund. However, the fund will also be purchasing newly-issued bonds which reflect the higher interest rate. These bonds will boast higher yields, which will increase the fund's average yield. The end result, then, is that investors may have an unrealized loss in the fund (due to the reduced price of bonds), but this loss will be partially offset by a higher yield (due to the addition of new bond holdings, which reflect the higher interest rates). By holding onto diversified bond funds such as BND, investors can enjoy the increasing yields. Better yet, reinvesting these higher yields lets you increase your position while the fund's price is relatively depressed and while its yield is increasing. Moving out of these funds entirely is akin to throwing the baby out with the bathwater: you avoid the decrease in price, but you also avoid the increased yield that accompanies rising interest rates. Any advice that rests on an investor merely "waiting" until interest rates rise sufficiently, and then reinvesting, over-promises. If the pattern of individual investing and market-timing in the wake of the financial crisis shows anything, it shows that investors are horrible at calling bottoms in the market.

Conclusion

Jack Bogle once referred to the financial media as the "Great Wall Street Marketing Machine." I admit, I lack Bogle's penchant for corny terms. But the machine has been in over-drive in recent years, crying out about the bond bubble and the great rotation. But the truth is that most passive investors should dismiss all of this as noise. True or not, it's irrelevant for many passive investors. Dollar-cost average and stick to your asset allocation. Yes, individual circumstances vary; exceptions to the rule always exist. However, for the most part, keep dollar-cost averaging. Maintain your asset allocation. By switching entirely to cash, stocks, and/or short-term bond funds, you rob yourself of returns. You also undercut one of the primary reasons for setting up a passive portfolio in the first place: to stop worrying about market timing, bubbles, rotations, recessions, booms, busts, and everything in between.

Source: Passive Investors: Stop Worrying About Bonds!