An Evidence-Based Approach To Fixed Income

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Summary

There is a great deal of noise surrounding what the best bond strategy is.

Many claim that investors need to reach for yield, but this is very contrary to why we have bonds in our portfolio to begin with.

The evidence contradicts this claim and proves that an evidence-based approach relying on high-quality fixed income yields a better outcome.

"In short, the evidence in support of the efficient markets model is extensive, and contradictory evidence is sparce." -Eugene Fama, Efficient Capital Markets: A Review of Theory and Empirical Work, The Journal of Finance, May 1970.

Introduction

With a great deal being written about the danger in bonds, it is important to escape from the noise, move away from the crowd and follow the evidence. While I have written a great deal in the past concerning the advantages of actively managing fixed income portfolios, and generally advocating an extended maturity position, it has become clear to me, after studying the evidence of academic research and reviewing volumes of live data, that actively managing a fixed income or equity portfolio fails to meet its stated objectives.

Source

Regardless of the period one looks at, the preponderance of the evidence is clear: Active fixed income funds have failed to beat a passive, or structured, alternative.

What is the Purpose of Owning Bonds?

We must start with what is the purpose of your bond allocation? We know from academic research that there is a significant equity premium from owning stocks over bonds. However, because most investors feel uncomfortable with the large swings in volatility that come from a 100% allocation to equities, many investors choose to own bonds. We own bonds to lower the volatility of the equity portion of the portfolio and to preserve wealth in accordance with an investor's goals. Investors are far better-served taking risk on the equity side of the portfolio. Therefore, the key to a winning bond allocation is that it accomplishes two purposes: 1. Preserves wealth. 2. Reduces volatility.

How to Invest in Bonds

The choice for many evidence-based investors has been to use the Vanguard Total Bond Market Index, or for those with access to Dimensional Fund Advisors, DFA Five Year Global Fixed Income. Both funds provide an array of bonds and exhibit low cost and volatility, preserving one's wealth over the long run. However, the opinions on which fund to use are mixed. John Bogle, the founder of Vanguard, has come out stating there are issues with the allocation in Total Bond Market Index and stating he prefers the Intermediate Bond Index. Other evidence-based investors have different views on how to approach fixed income. With so many excellent opinions surrounding fixed income, what is an investor to do?

Let us step back and explore the purpose of our bond allocation once again. The purpose of bonds is to preserve wealth and reduce overall volatility. The way bonds reduce volatility is having a negative correlation with the equity side of the portfolio. Therefore, it would seem investors would be well-served by allocating to the safest kind of bonds available, such as CDs, US Treasury bonds, or US Government bond funds, over those that favor corporate bonds, which tend to be more correlated with the equity markets. Let's review the live data during the 2008 financial crisis.

Case Study: 2008 Financial Crisis

Let's examine the behavior of various bond funds during the financial crisis period, 2007-2008. It's during periods of market stress that we want the bond allocation of the portfolio to cushion the volatility of the equity allocation and help to preserve wealth of the entire portfolio. This allows an investor to stay invested for the long run. So let's see which vehicles accomplished this objective the best. We will look at the Vanguard Short-Term Treasury (MUTF:VFISX), Vanguard Intermediate Term Treasury (MUTF:VFITX), Vanguard Intermediate Term Bond (MUTF:VBIIX), Vanguard Total Bond Market Index (MUTF:VBMFX), DFA Five Year Global Fixed Income (MUTF:DFGBX), and DFA Intermediate Government Fixed Income Fund (MUTF:DFIGX).

2007

2008

Total

Vanguard Short Term Treasury

7.89%

6.68%

14.57%

Vanguard Intermediate Term Treasury

9.98%

13.32%

23.30%

Vanguard Intermediate Term Bond

7.61%

4.93%

12.54%

Vanguard Total Bond Market Index

6.92%

5.05%

11.97%

DFA Five Year Global Fixed Income

5.22%

4.02%

9.24%

DFA Intermediate Government Fixed Income

9.53%

12.88%

22.41%

S&P 500 Index

5.39%

-37.02%

-31.63%

As we can see, each of the bond funds did a good job of buffering volatility; they are all great choices. But it is important to note that the US Government and US Treasury funds did the best job of cushioning volatility during times of stress.

While we know from academic research allocating a portfolio tilted to small caps and value stocks tends to produce superior results, for illustration purposes lets keep it simple. An investor who held a 50/50 portfolio of 50% S&P 500 and 50% DFA Intermediate Government would have suffered a loss of only -4.61%, from 2007-2008, during what many refer to as the greatest financial crisis since the great depression. Here we can see the advantages of using DFA and committing to a high-quality fixed income strategy.

Structured Beats Active: A Case Study in Fixed Income

In contrast, some of the most popular active bond managers failed to produce results that were equivalent or better than DFA Intermediate Government and did so at much higher cost. Below are four of the largest active bond mutual funds. All of them failed to provide adequate cushion to investors during the 2007-2008 financial crisis, with two of them even posting a negative return in 2008. At a time when they were needed most, they turned out to be much more correlated with equities. Which leads to the question: Why wouldn't you just own equities?

2007

2008

Total

PIMCO Total Return

8.73%

4.48%

13.21%

TCW Total Return

6.18%

0.90%

7.08%

Metwest Total Return

6.48%

-1.28%

5.20%

Dodge & Cox Income

4.68%

-0.29%

4.39%

Conclusion

Following the evidence and employing the science of investing by harnessing the insights of academic research to engineer a portfolio to sustain over the long run is the key to a winning investment strategy. Keeping in mind what the purposes of each asset class are, keeping costs low, and following a structured approach to bond fund allocation is the path to a winning bond allocation.

Disclosure: I am/we are long DFIGX.

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: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor.