Are Bonds Still Relevant?

by: Financial Path

Summary

The yields have dropped to record lows and the future might look bleak.

Should you still invest in bonds given today's markets?

A 100% equity portfolio might be the answer to the bleak outlook of bonds.

If you read a lot of investment blogs or listen to investment news, you might have heard that bonds are earning next to nothing these days. The yields have dropped to record lows and the future might look bleak.

People complaining about how risky the stock market is ought to take a look at the so-called safety of today's bond market. - Kelly Evans, CNBC

In addition, some say that you should always invest a portion of your portfolio in bonds according to your age. Financial planners used to say:

Subtract your age from 100 - and that's the percentage of your portfolio that you should keep in stocks.

But now most planners are using 110 or 120 minus your age since people are living longer and need the extra growth that stocks can provide. As I see it, bonds play a lesser role in portfolios than they once did but you shouldn't disregard them completely.

Historically

Looking back, bonds acted as volatility stabilizers for investment portfolios. They often rise in price when stock prices fall or at least, keep their value. Below you can see how the Vanguard Total Bond Market (MUTF:VBTLX) compared with the S&P 500 index in the last 10 years.

vanguard bond etf

Credit Vanguard

You can easily see how bonds (the blue line) kept a steady uptrend even during the 2008 market crash. However, the S&P 500 index clearly got ahead in the following boom. Doing this on longer-term periods will show an even bigger discrepancy between returns. The yield on a U.S. 10-Year Treasury Note, pretty much the safest bond you could get, has fallen from 14% in 1984 to 8% in 1994 then to 4% in 2004 and to under 2% today.

Looking back since 1926, having a considerable portion of your portfolio in bonds would have reduced volatility without greatly reducing total returns but those conditions no longer exist. Today's rates are so low that there is little room to fall and at some point will go up. Once rates start going up, bond prices will fall.

I don't think that the old rules of thumb stands any more. The rates are at record lows and the long-term prospects are dim.

As a fun exercise, I tried multiple scenarios in FIREcalc to get an idea of the difference. FIREcalc is a retirement calculator that uses Monte Carlo simulations to see how your portfolio would have withstood the different periods of time throughout history. If your retirement strategy would have withstood the worst ravages of inflation, the Great Depression, and every other financial calamity the US has seen since 1871, then it is likely to withstand whatever might happen between now and the day you no longer have any need for your retirement funds.

After entering a topical $1M portfolio withdrawing 4% annually (following the Trinity study), FIREcalc looked at the 116 possible 30-year periods in the available data and concluded that for a 100% equity portfolio, the lowest and highest portfolio balance at the end of the periods was $-931,017 to $8,509,297, with an average at the end of $2,686,348. It found only 8 cycles that failed, for a total success rate of 93.1%.

With a 90% equity portfolio, the lowest and highest portfolio balance at the end of the 30-year periods was $-676,978 to $6,924,916, with an average at the end of $2,337,419. The success rate slightly increased with only 6 cycles failed and a success rate of 94.8%.

For a more conservative portfolio of 65% equity, (35% bonds is about the "riskiest" allocation most financial advisers would suggest to clients, some go as far as 50% in more conservative cases) the lowest and highest portfolio balance at the end was $-301,852 to $4,921,485, with an average at the end of $1,543,147. FIREcalc found only 5 cycles failed, for a success rate of 95.7%.

With this data, you can clearly see the astronomical opportunity cost of "security." Going from no bonds to 10% in bonds would have cost you $1,584,381 in the best period for only 1.7% more chance of success! Choosing a 35% bond allocation would have cost you a crazy $3,587,812 just for 2.6% more chance of success, or in other words, almost $1.4M per percentage points.

Retirement

If you are like me and still have years before retirement, a large bond allocation might not be ideal for your portfolio. The main advantage I see in bonds is the stability they could offer if I would be withdrawing from my portfolio. During my whole accumulation phase, I prefer opting for better long-term returns of equity. If we look at the S&P 500 over the past 70 holding periods of 20 years, starting with 1926 to 1945 and going forward in 20 periods, not a single term has posted a loss.

I would argue going 100% stocks is more risky in the short term but is actually safer in the long term. Such an allocation would optimize your returns and might allow you for an earlier financial independence.

Now, once you retire, bonds might serve a purpose. If you would need to withdraw from your portfolio each year and encounter a recession in the first few years of retirement, your success rate would drop considerably. Starting a withdraw phase in 1929 or 1930 would have been devastating and you would then need to go back to work, or considerably reduce your spending.

In the exercise above, the few failed scenarios in FIREcalc where all periods starting in the worst market conditions in history. Having bonds allows you to withdraw that portion of your portfolio first before selling off any stocks. For that reason, changing your allocation might be suitable in the first few years of your retirement but not before or after.

Allocation

To determine how much you need to allocate to bonds, I suggest thinking about the amount you would need to live through a recession. As shown below, market crashes historically recovered quite rapidly. For a 40% drop like we have seen in the 2008 crash, it's estimated to recover in only 1.8 years.

will we recover market crash

Data: NYTimes Chart Credit: FlannelGuyROI

Me, I used 1 full year of living expenses, this would allow me enough time to liquidate some positions and greatly increases my rate of success in early retirement. If you feel comfortable with the market swings and are investing for the long haul, you can have a 100% equity portfolio until you approach your retirement target. Once you are close to retirement, you can allocate your desired amount to bonds but I would not look at in terms of percentage of your portfolio.

Diversify

The one thing I need to underline when suggesting that a 100% equity portfolio is that you need to stay diversified. I would not recommend this allocation to someone who picks individual stocks and only has a handful of companies in his portfolio. I suggest investing in index funds such as the Vanguard Total Stock Market (MUTF:VTSAX) given its broad diversification. If you can choose an index fund, keep in mind the most important factors of a good fund:

1. It should hold at least 1500 individual stocks

2. It should have a low management fee (0.05% to 0.30%)

3. It should be easy to buy and sell at no or very low cost

Once you are invested in a properly diversified portfolio, your allocation should outpace over the long term if we compare to historical data. Of course, past performance does not guarantee future results so I will let you get to your own conclusions after the data and arguments I presented. You can also read why I think that market drops are not always bad if you are properly diversified in a previous post.

What About Me?

If you read my Open Book Series, you can see that I currently have a 95% equity portfolio. After research, I concluded that I am too young to hold any bonds at all and that I should optimize my long-term potential return by opting for a 100% equity portfolio. However, I started investing in bonds at the beginning of my accumulation phase and now I do have this small amount idling in my registered account (401(k)).

I currently invest all my new contribution in equities and don't intend to increase my bond allocation before retirement. I will sell my small balance currently in bonds at my next annual rebalancing and go towards a 100% equity portfolio.

I hope this gave you a little idea about the possible asset allocations, Be Happy, Xavier.

Disclosure: I am/we are long VTSAX, VBTLX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.