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My recent article suggesting that investment grade bonds, in this current low interest rate environment, were more likely to lock in a loss than to stabilize portfolio returns, engendered a lot of interest and very thoughtful comment. One of the most interesting aspects of the discussion centered around the traditional role of bonds in providing un-correlated diversification to a portfolio. The idea behind that, expressed in plain English that I (an old-fashioned seat-of-the-pants investor, but not a sophisticated “portfolio theorist” – i.e. don’t ask me to define “convexity” or “efficient frontier”) can understand, is that you might have, say, 60% stocks and 40% bonds in your portfolio with the expectation that (1) the stocks might earn you 15-20% in a given year, but they might also earn you 3% or even minus 10%, (2) the bonds would be the stable anchor investment that earns you less but in a more predictable, less volatile range (i.e. most years around 5%, but maybe only 1% or as much as 8%) and (3) putting it all together your risk-adjusted long-term return would be better than if you just held either asset class by itself.

That sounds reasonable and, for many of us, our own experience of the past several decades has borne it out, whether we have created balanced portfolios of our own (some stocks, some bonds, by mixing individual stocks, bonds and mutual funds of various kinds) or whether we bought balanced funds that did it for us (Vanguard Wellington, Fidelity Balanced, etc.)

The point I have been raising in my recent Seeking Alpha article and in some other writings is whether we are at a generational inflection point with regard to interest rates, and how that changes – or, at least, should change – the traditional attitude toward the use of fixed-rate bonds in an asset allocation program. Frankly, I believe that all those years when investment strategists and portfolio managers routinely recommended pairing stocks and bonds in a portfolio, there was an implicit assumption that interest rates could go either way and that the “interest rate bet” (i.e. that rates would either stay the same or go down) that is part and parcel of every fixed rate bond investment, had at least a 50-50 chance of paying off. Now, after 30 years of falling interest rates that have made bonds a terrific investment over that period, rates are so low that the interest rate bet inherent in bonds has become a sucker’s bet with a much smaller chance than 50-50 of paying off.

This raises the question of why you would want to diversify into an un-correlated investment if the investment is likely to drag down your performance. This is not to say that stocks are any less volatile than they ever were, but only to point out that diversifying with an asset like fixed rate bonds that looks like a loser is not likely to help overall performance the way it did over the past 30 years.

How much of a drag depends on your view of interest rates – how soon they will rise and by how much – but the following table gives an idea of how typical bond portfolios might be affected.

Investment Type Average Duration SEC Yield Loss with 1% rise Loss with 2% rise Loss with 3% rise
Vanguard LT Bond Index (MUTF:VBLTX) US Gov't & Inv. Grade Bond Fund 14 3.86% 14% 28% 42%
Vanguard LT Treasury (MUTF:VUSTX) US Gov't Bond Fund 15 2.30% 15% 30% 45%
SPDR Barclays Int. Term Treasury (NYSEARCA:ITE) US Gov't Bond ETF 4 0.70% 4% 8% 12%
SPDR Barclays Int. Term Corporate (NYSEARCA:ITR) US Inv. Grade Corp ETF 4.5 3.10% 5% 9% 14%
SPDR Barclays Int'l Corp. Bond ETF (NYSEARCA:IBND) International Inv. Grade Bond ETF 4.4 3.3 4% 9% 13%

This shows a variety of representative bond funds and ETFs, all holding primarily government bonds or investment grade corporate bonds. As you can readily see, the downside risk in the event of a modest 1% to 3% rise in interest rates, not a stretch at all from where we currently are if you think inflation and/or interest rates will be on the rise in future years, is substantially more than any holder is being paid to take. Long-term government bondholders are being paid 3 or 4% to take a risk of their capital falling by 30% or more if rates increase by 2%. To my mind, not a good bet, and I can’t see where adding that to one’s portfolio will help an investor sleep better at night. Even with intermediate bonds, the risk of a 1% interest rate rise wiping out an entire year’s income, and a 2 or 3% rise throwing you into a possible double-digit loss doesn’t seem like a very good way to add stability to a portfolio.

Many pension and endowment funds and the consultants that advise them have recently begun to realize this and are looking at other asset classes, especially floating-rate loans and equity products with fixed-income-like stability (MLPs, utilities, convertibles, etc.) as ways to partially replace their traditional reliance on bonds. Retail investors actually have the opportunity to be more nimble than most institutional investors, and can use closed end funds (e.g. EFT, BSL, PPR, NTG, CEM, EMO), exchange-traded funds and conventional mutual funds in order to diversify out of equities into lower duration and higher yielding asset classes, as I have pointed out in recent articles. (here and here)

Disclosure: I am long EFT, BSL, PPR, NTG, CEM, EMO, ITE, ITR, IBND.

Additional disclosure: I am a freelance writer and occasionally am paid to write about fixed income, investment strategy and related themes.

Source: Bonds As Dinosaurs (Part 2): Diversification At What Price?