Don't Junk Your Retirement Plan

| About: Vanguard High (VWEHX)

Summary

Junk bonds are popular because of the belief that they are relatively low risk and offer acceptable cash flow payouts.

Combining a diversified stock portfolio with high-quality bonds is a more efficient way to generate ongoing retirement income and works better in a variety of different environments.

Historical simulations and foward-looking estimates show that traditional balanced portfolios result in significantly greater long-term wealth accumulation compared to junk bond strategies.

I've written about high-yield (aka "junk") bonds before, but they are such a common retiree destination, I figured I would approach the topic a little differently this time.

A Bird In The Hand

First, let's point out why retirees are attracted to junk bonds (a similar line of thinking applies to dividend-paying stocks, REITs and preferred stocks as well). Once you stop working, even a back-of-the-envelope calculation will tell you how much annual income you need. Subtract out Social Security and maybe a pension or rental income, and you arrive at the amount your investment portfolio needs to supply.

Let's say you have a $1,000,000 investment portfolio and your first year income requirement is $40,000. What's easier than going out and finding a portfolio of bonds that pays about 4% per year? Bonds, the thinking goes, are relatively safe, and you earn all the income you need to match your spending needs. So junk bonds are popular with retirees.

Breaking Down The Asset Classes

Now that we have the basic liability-matching framework down, let's discuss what junk bonds are, relative to investment-grade bonds and stocks.

When you own stocks, you have a fractional share of ownership in a company, or thousands of companies when you own a mutual fund. That ownership entitles you to a share of the gains achieved by the company, which come in the form of dividends and capital appreciation. Historically (since 1926), the combination of appreciation and dividends has rewarded owners of large U.S. companies with about a 10% annual return.

When you own bonds, you have no ownership. You've made a loan to a company or to the government for a specified period of time, and in return, you earn a periodic interest rate. At the end of the loan, you hope to receive your principal back and you keep all of the interest you've earned. Despite reduced upside opportunities compared to stocks, the risks of bonds are relatively smaller, so the returns that bondholders earn is less. Since 1926, the total return on a portfolio of short-term government bills has been about 3.5%, and for the longest-term (20+ years) corporate bonds, almost 6%.

So where do junk bonds fit in? They are issued by companies that are in the most precarious financial situations. Junk bond companies don't want to have to pay the highest rates of interest to their lenders, because the more money they give up, the less they have to manage the business. But they have to, because lenders know there's a relatively high likelihood that they won't get all of their principal back, at least on time, and that one or more interest payments will be missed.

A high interest rate is the only chance they have to get a loan. Remember, these companies are not in great financial shape. And when do these companies have the hardest time meeting their bond commitments? When the overall economy declines, or there are specific issues within their industry. Does this risk sound familiar? It should, because it is the same environment that could cause stocks to perform poorly. More on this shortly.

High Return = High Risk, Even In Bonds

All this is to say that there is a reason why the yields on junk bonds are relatively high - because their risks are high. Forget about the "bond" part for a minute, because if your borrower defaults, that bond is broken. What we have is a fairly risky investment with returns that come mostly in the form of interest and whose principal value is most in question when the economy is doing poorly or when interest rates rise.

So, with junk bonds, there's risk, and a fair amount of it. Hopefully, you see that it's this risk that drives the higher expected returns compared to relatively safer investment-grade bonds. The longest data we have on junk bonds reveals a return of +8.9% per year from 1983 to 2016. That's almost 2% per year better than default-free, 5-year U.S. Treasury Notes, which did +7.0% per year.

A Better Risk/Return Mix?

But riskier bonds aren't the only way to increase your portfolio's expected returns. Over the same period, the S&P 500 Index returned +10.7% a year, about 2% per year more than junk bonds and 3.7% per year more than investment-grade bonds. A more diversified stock portfolio that also includes large and small value stocks (the same companies that tend to issue junk bonds) as well returned +12.5% per year. That's almost 2% a year more than the S&P 500, 3.6% per year more than junk bonds, and 5.5% more than traditional bonds.

It stands to reason, then, that an alternative to the riskiest junk bonds is to start with a diversified stock portfolio, and add only the amount of investment-grade bonds necessary to reduce portfolio risk and set aside enough years of future portfolio spending (in bonds) to weather multi-year bear markets.

This approach has three added benefits. Number one, it has higher expected returns. A 65/35 combination of the diversified stock mix and 5-year T-Notes returned +11% annually since 1983, 2% per year more than junk bonds without more risk. Number two, it is more diversified, so you have additional opportunity to harvest your income in different market environments.

When stocks are gaining in value, selling off some shares to meet income needs helps keep your portfolio balanced. When stocks are down, high-quality bonds have typically gained in value, providing you with an alternative source of withdrawals as you wait for stocks to recover. A third consideration is that the combination of stocks and high-quality bonds is more tax efficient, as much of the growth comes in the form of long-term capital gains and not ordinary income.

The Real World

The preceding data is based on index simulations, and not purely representative of real-world retirement challenges. To remedy this, let's consider an actual retirement example with live mutual funds.

An investor retires in 1995 with $1,000,000 and needs 5% ($50,000) annually plus inflation. Their first option is to invest it all in the Vanguard High-Yield Corporate Bond fund (MUTF:VWEHX), the lowest cost, most diversified high-yield fund in the market. The second option is to invest it in a globally-diversified portfolio of stocks (65%) and short-term bonds (35%). The stocks will include value and small cap diversification (VFINX, DFLVX, DFSVX, DFIVX, DISVX, DFGBX). Details of the simulation can be seen here.

What were the results? After 21.5 years through June, our retiree's income needs had grown from $50,000 per year to $79,0000 annually. That's because of inflation, an issue many retirees who are matching current spending needs with current portfolio income often forget. Over the entire period, the total amount of income needed was $1.38M - more than the original starting portfolio value. Retirement is expensive, in case you haven't already figured that out.

How about our two investors? The junk-bond investor wound up with $1.42M in principal by mid-year 2016. The balanced portfolio investor? $2.94M. That is more than double the ending-value amount. And the amount of "risk" each investor had to endure was approximately the same. In 2008, for example, each portfolio had a decline in the low -20% range. The main difference in outcome was the almost 2% per year higher return from the balanced approach (+8.6% per year) compared to the junk bond effort (+6.8%).

Going Forward

We've got the past covered, and that counts for a fair amount. Knowing what has worked well, assuming it's based on sound financial principles (risk/return, diversification, etc.), is a helpful guide to the future.

But what about the future? We know junk bonds won't come close to the +6.8% per year return they've seen since 1995. Nor will high quality, short-term bonds for that matter. The DFA Five-Year Global Fixed Income Portfolio Inst (DFGBX) used in the above illustration returned +5.4% annually, just 1.4% less than the much riskier Vanguard High-Yield Corporate fund.

If we see more than 4% and 2.5% out of these two funds over the next 10 or 20 years, that would be a surprise. If it were to happen, it would be because interest rates rose, a condition that would be significantly more beneficial for short-term investment grade bonds than relatively longer maturity junk bonds.

But stocks have a much better chance of earning the 9% to 10% returns we saw from them in the example above (9.6% to be exact). Valuations today on U.S. large cap stocks aren't any higher than their average over the last 21 years, assuming returns and valuations are correlated (which is a stretch).

Shares of smaller and more value-oriented stocks in the U.S. trade at appropriate discounts to safer blue chip companies (read: higher expected returns), and the decade-long slump in foreign stocks could result in much higher future returns overseas, especially on value and small cap companies.

All this means that the relative difference between a high-yielding, junk bond approach and a more balanced, diversified allocation over the next 10 or 20 years could be even greater than the last two decades. Is an ending retirement portfolio value from a balanced approach that is triple the size of a high-yield strategy outside the bounds of expectation? I don't think so. And I wouldn't bet against it with my retirement dollars. Said differently, I wouldn't junk my retirement plan.

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Past performance is not a guarantee of future results. Index performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. You cannot invest directly in an index. This content is provided for informational purposes and is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.

Disclosure: I am/we are long DFLVX, DFSVX, DFIVX, DISVX.

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.

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