Bonds: Don't Fear The Reaper

Includes: JNK, SPY, TLT
by: Dale Roberts

All the talk about bonds, you'd think they're sounding the portfolio death knell for investors, and the balanced portfolio.

Google "The death of bonds" or "bonds are dead" or "bonds are dead money" and you'll get a few pages of suggestions. And you'll find some interesting reading.

Certainly bonds carry risk. There's the risk of default, that the bond issuer whether it be a government or a company goes out of business. Though bonds are certainly at the top of the food chain when that issuer goes bust.

And bonds carry price risk. As you may know, when interest rates and yields increase, bond prices fall. And they can certainly fall hard. And the longer the bond or bond fund duration the greater the price risk. The basic formula goes as this; if the duration is 10 years and the yield on that bond increases by 1%, the price will fall by 10%. If the duration is 10 years and the yield increases by 2%, the bond or bond fund price will fall by 20%. Of course any fall in bond price will be offset by any income or yield delivered by that bond or fund.

If you have a 20% price drop and a 4% yield, you're down 16% on a total return basis. Of course, you'd only have turned that total return loss into reality if you sold your bond holding.

There is certainly price risk that has been exaggerated by the precipitous fall in yields from 1981. It's been quite the party for bond investors over the last 30 something years.

Yields are at historic lows. That certainly increases the risk for bond yields to increase over the coming years and decades. Looking at the above chart we can see that yields can spike in a hurry, and then can increase over an extended period.

That said, even from historic lows, bond prices could stay low, for an extended period - even a decade or more. The party might continue, or at least hit the pause button.

The period that most resembles today is the 1940's and 1950's when the U.S. also had very low interest rates and troubling debt issues. Back in 1940, the bond party had just lasted some 20 years from 1920. Treasury yields in the 2.5% area. So what happened? Check out that long-term chart above and you'll see that yields fell to 2.09% and then crested above that 2.5% area, only to then again increase back to the 2.5% yield in mid-1950's. Over that 15-year period, there certainly was some volatility along the way, but the bond investor who had received that yield and reinvested that yield into their bonds was rewarded.

Here's an example of yields on 10-year and 3 month Treasuries.

Does this mean that we will see no meaningful bond hurt until 2028? I have no idea. If anyone suggests to you that they know what will happen to the bond markets and yields on a shorter or mid-term basis, run for the hills.

That said, the period from 1955 through to the early 1980's delivered some pain over that extended period. And one should be cautious, there were periods, especially in the 70's when bond prices were crushed. There can be equity-like price moves.

That said, and as I outlined in the article Asset Allocation is Alive and Well, a 60-40 balanced portfolio from 1950 to 1964 delivered returns of 600%. And yes the heavy lifting (all the lifting?) was done by the stocks that went on one of their greatest bull runs in history. When bonds do have trouble in price terms, the equity markets are usually there to say "hop on, I'll carry you for a while."

And yes, there's that period when nothing worked, from 1965 to the early 80's. Here's an article on that time period, coincidentally entitled When Nothing Works, What Do We Do? Yes that article is not for the squeamish. And that article is certainly not well read on Seeking Alpha as of yet. I understand why, but please have a read as I do still have two kids to send to University. I can't be guaranteed that my son will be on a baseball scholarship, but he's looking pretty good.

Those who practiced asset allocation and who also hoped that the equities in their portfolio would pick up the slack in that period were sorely disappointed. While stocks and bonds can often offer low or negative correlation, there's no guarantee. The S&P 500 (NYSEARCA:SPY) from 1966 to the early 80's delivered very little. As I stated in that article, even with reinvested dividends, the equity markets delivered nothing against inflation over an extended period from 1966 to 1982. Yikes. Adding new monies at market bottoms was one of the practices that would have allowed an investor to eke out some gains against inflation.

When nothing works, cash will be king. Cash will be your best friend. Dry powder will be the only weapon you have. Dividends and bond income to reinvest will help the cause, but only marginally. Having investable funds available to load up when the markets go on sale will be crucial. If you fear another period when nothing works; in the late 60's and through the 70's it was called stagflation, then you might want to consider moving some funds to cash. Stagflation of course is when we have inflation combined with no meaningful economic growth.

And as I pointed out in that article, you might want to consider a generous allocation to gold, cash, bonds and stock. The permanent portfolio delivered in that period when nothing worked.

Dang, and I am sad to report that my fellow Canuck and notable economist David Rosenberg has recently declared that stagflation is on its way.

"My sense is that once this consumer deleveraging cycle is over, and there are signs that it is coming to an end if it hasn't ended already, you're going to see the velocity of money start to rise, against the backdrop of double-digit growth of the monetary base, and that is going to lead to inflation down the road."

Luckily though, he predicts a mild form of stagflation. Phew.

And perhaps even more comforting is that for the last few years he has been predicting deflation. Predictions are hard to make, especially about the future.

And that lack of ability to predict is exactly the point as to why one should not fear bonds or the bond reaper. The reason many investors and advisors choose bonds is to manage investors' risk tolerance levels. Bonds are the traditional asset class that tempers portfolio volatility when held in concert with equities. For example, while equity markets fell over 60% in 2009, our balanced income portfolio was never even down by 10% in its worst days and weeks. Our classic 60-40 balanced portfolio was down by about 20%. That's a level of volatility that many investors can stomach. An investor's risk tolerance level will not often change overnight. Bonds' ability to temper volatility is not likely to change. Chances are that bonds will continue to moderate portfolio volatility moving forward. But as always there is no guarantee that that phenomenon will occur.

And while many investors hold bonds to manage risk, others have traditionally purchased bonds for the income. Many will argue that the income delivered by bonds and bond funds is not worth their time in the present environment. So if rates increase and bonds enter a cycle where they deliver a higher yield, well isn't that a good event on the income front? Who doesn't like a growing income? Certainly dividend growth investors seek that growing income. Granted, the battle with bonds will be higher income available, but with falling prices. Bond investors will have to learn to ignore price swings and keep their eye on the income, and the portfolio's total value.

The future of bonds

What can we do but look at the past? That's all investors really have to go by as we can't predict the future. Looking back, there's the possibility that bond yields will stay relatively low even for an extended period of 10 to 15 years.

There's the possibility the long-term bond yields will increase modestly from the area of 3% to 8% over a period of 20 years. That is certainly a significant move. But annualized or averaged, that's only a move of a quarter point per year. That's almost nothing to sweat. That would deliver a period of very low or modest total returns for bonds and bond funds over that period - a scenario that Vanguard expects or predicts is the most likely outcome.

And there's the scenario where bond yields spike in quick and violent fashion. Long-term rates can certainly spike at over 1.5% per year for a few years running. We've recently seen 10 and 20-year Treasuries make a significant move already in 2013.

It's up to each individual investor to weigh the possibilities and analyze their own risk profile and also consider what they need their portfolio to deliver. We're not defenseless as bond investors or holders of balanced portfolios. We can shorten up on duration to reduce the risk of rising yields and rates. That said, it appears that holding some longer duration Treasuries (NYSEARCA:TLT) or funds with a very modest allocation to lower grade and higher yielding corporates (NYSEARCA:JNK) may provide some greater yield and lower the bond portfolio's overall volatility. As was reported this past weekend in my favourite newspaper, the National Post, risky bonds are beating up on top rated debt.

Securities ranked in the CCC tier or lower by Standard and Poor's have gained 7.1% this year compared with a 5% loss for AAA debt.

And as you may likely know, lower grade corporates can move more in concert with equities than long or mid-term bonds. And they are typically less interest rate sensitive.

Net, net, and in my humble opinion (imho as they write in text-land) bonds in a balanced portfolio are worth the risk. It appears that there is a greater probability of generous to modest gains in a balanced portfolio than losses or steep losses over longer time horizons.

Bonds - live long and prosper.

Disclosure: I am long SPY, DIA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Dale Roberts aka cranky is a Streetwise Coach at ING Direct Mutual Funds. Streetwise Portfolios offer Canadians the lowest-fee, complete, index-based portfolio options. Dale’s commentary does not constitute investment advice. The opinions and information should only be factored into an investor's overall opinion forming process

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