This is the final article is a series that explores alternatives to holding long term government bonds in a portfolio. The inspiration for this series was an interview with Warren Buffett where he called long-term government bonds the "dumbest investment." The other articles in the series are:
I hesitated writing this article because it challenges conventional wisdom, and violates some widely accepted principles of portfolio management. My hesitation however was removed once I learned that according to Morningstar (MORN), 309 bond funds now own equities in their portfolios.
According to investment-research firm Morningstar Inc, 309 bond mutual funds owned stocks at the end of December, the highest number in at least a decade.
Because it is already being done in bond funds, I feel it is safe to explore the concept of holding equities in the fixed income portion of a portfolio. An investor would of course not want to hold 100% equities in their fixed income segment, it would be best to balance equities with some of the alternative discussed in the previous articles.
The key is to find equities that perform similar to bonds, but will provide better protection in a rising rate environment. Equities have one advantage over bonds for a rising rate environment in that their dividends are not fixed, allowing them to lessen the impact in a manner similar to TIPS.
Not just any equity would qualify as a possible alternative to bonds. Appropriate equity options would be MLPs, high dividend paying stocks, utility stocks, preferred stocks, REITS, and while not technically an equity, convertible bonds. The key is to have a dividend stream to replace the interest payments from the bonds.
The analysis is similar to the other articles. The objective is to find equities that have similar risk and return characteristics with iShares Barclays 20+ Year Treasury ETF (TLT), but a low correlation. The return and standard deviation statistics are the top two rows of the correlation matrix, and the first column of numbers are the correlation statistics. The downward sloping diagonal line of 1s is the result of the security being correlated with itself.
Each one of these options would possibly qualify as an alternative to TLT.
The iShares Dow Jones U.S. Utilities Sector Index Fund (IDU) has a return greater than TLT, 14.35% vs. 13.47%, and a lower standard deviation, 9.56% vs. 14.81%. It also has a -0.25 correlation, as well as a 3.23% 12-month yield. Those are the kinds of statistics an investor would look for when seeking to replace a bond with equity.
The iShares S&P U.S. Preferred Stock Index Fund (PFF) has a return less than TLT, 8.35% vs. 13.47%, and a lower standard deviation, 8.29% vs. 14.81%. It also has a -0.44 correlation, as well as a 5.97% 12-month yield.
The iShares Cohen & Steers Realty Majors Index Fund (ICF) has a return greater than TLT, 16.44% vs. 13.47%, and a higher standard deviation, 17.42% vs. 14.81%. It also has a -0.59 correlation, as well as a 2.93% 12-month yield.
The iShares Dow Jones Select Dividend Index Fund (DVY) has a return greater than TLT, 15.47% vs. 13.47%, and a lower standard deviation, 11.46% vs. 14.81%. It also has a -0.63 correlation, as well as a 3.47% 12-month yield. This security meets all the criteria, but an investor still needs to see how the security impacts the existing portfolio, paying special attention to the changes in sector weights this holding would cause.
This chart demonstrates how correlations will shift over time, highlighting the importance of periodic portfolio reviews.
iShares S&P Global Consumer Staples Sector Index Fund (KXI)iShares S&P Global Utilities Sector Index Fund (JXI) iShares FTSE EPRA/NAREIT Developed Real Estate ex-U.S. Index Fund (IFGL) iShares S&P Global Infrastructure Index Fund (IGF) iShares Dow Jones International Select Dividend Index Fund (IDV)
Out of the above list, KXI has the best profile 14.81% annualized return, 11.54% standard deviation, -0.54 correlation and 2.55% 12-month yield. JXI does not appear to be a viable alternative with its 2.42% annualized return and standard deviation of 11.54%.
Because of the limitations of the system used to calculate these correlation matrixes as well as the limited data available for some ETFs, not all options listed in the introduction are included in the charts, namely MLPs and convertible bonds. The following chart is a watch list of ETFs with a limited amount of data. The one year time horizon makes the correlation statistics meaningless, but with time, they will become more meaningful.
iShares S&P Emerging Markets Infrastructure Index Fund (EMIF) iShares FTSE EPRA/NAREIT Developed Real Estate ex-U.S. Index Fund iShares Emerging Markets Dividend Index Fund (DVYE) iShares S&P International Preferred Stock Index Fund (IPFF) iShares Dow Jones International Select Dividend Index Fund
In conclusion, with long term interest rates at or near historic lows, the risks of owning long term bonds may outweigh the benefits. Already bond mutual funds have started to add equities to their portfolios as protection against increasing long term rates. While that certainly is not a tradition approach to portfolio management, given the unique circumstances, it may be an appropriate consideration, at least for a portion of the fixed income allocation. This series of articles is an effort to provide readers with possible alternative to their long term bonds. Before making any changes however the investor should have a clear understanding of the risks and returns of the new strategy, and how it will impact the entirety of their portfolio.
Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.