I receive an email like this from time to time.
My assets are currently about $1.8 Million. I am heavy in cash, 67% stock (56:43, US:Intl) and 33% bonds (77:23 US:Intl) and the rest in REITs. I'm ready to retire at 51 and am contemplating a move to a more conservative portfolio (i.e. more bonds). I've spent many decades thinking about stocks, but have given bonds little effort. I have just started reading The Bond Book by Annette Thau which mostly is convincing me that since interest rates are doubtless headed higher, bond funds are a suboptimal place to park money….A lot of your advice is very helpful for folks getting to FIRE. What does one do when one gets there?!?
I don't know how this idea about bond investing gets out there. It's like people get a little bit of knowledge about bonds but never seem to get the full message. I guess it's the classic example of “a little knowledge can be dangerous.” People know that “bonds go down when interest rates go up” but they don't seem to get any understanding of how much they go down or what happens afterward. This fear of rising rates is so prevalent, and has been for years, that one of the very first posts I wrote for this blog in May 2011 was called Are Bonds a Crappy Investment? At that time I wrote the following about bond investing:
Over the last year or two, I have seen a number of articles in the financial press suggesting bonds are a lousy investment. When you really get into it, the main argument put forth is that “interest rates are as low as they can go, and since bonds do badly when interest rates go up, they must be a lousy investment.” Aside from the obvious point, that interest rates aren’t as low as they can go, and the fact that they may stay quite low for a long, long time, there seems to be a real misunderstanding of the concept of interest rate risk.
Guess what bond returns were over the next 7 years “when interest rates had nowhere to go but up”? Let's take a look.
Does that surprise you? There are six lessons to learn here, most of which are illustrated well by that simple chart.
6 Lessons to Learn About Bond Investing and Interest Rates
# 1 Interest Rates Don't Have To Go Up
The first lesson is that sometimes what the media and investors believe to be a “sure thing”, often is not. Just like people today are saying “interest rates have nowhere to go but up”, they were saying exactly the same thing in 2011. Not only did interest rates NOT go up, but they actually went DOWN! Here's the 10-year treasury yield over that time period:
As you can see, in May 2011, the 10-year treasury was yielding 3.2%. It didn't hit that level again for 7 years and even now is below that level. In fact, the first thing it did was fall to 1.5% over the next year! Let's look at another example, perhaps the classic example of low long term interest rates–Japan.
As you can see, it is entirely possible for rates to go down and stay down for long periods of time. Could that happen in the US? Absolutely.
Predicting interest rates movements is at least as difficult as predicting future stock market movements and timing the market is just as perilous. Sure, you can rely on the Fed's statements for the next 3-12 months to get some idea of what they are going to do with the interest rates that they control, but by the time you read their statement, that information is already priced into bond prices.
# 2 There Are Two Components to Bond Fund Returns
I'm not sure why people think bonds are complicated. Frankly, I find them simpler to understand than stocks. There are generally three components to stock returns — the dividend yield, earnings growth, and a speculative component. With bonds, there are only two (the yield and the temporary change in value due to default and interest rate risk) and for high-quality bonds held to maturity, there is really only one. The “duration” of a stock is basically infinite, but even the longest-term bonds are only 10-30 years.
Duration
Speaking of duration, this is a good time to explain this critical principle of bond investing. The duration is a period of time usually shorter than the maturity of the bond that shows the effect of changes in interest rates on the value of the bond. It's a quick and easy way to look at a bond mutual fund and get a good idea of just how much changes in interest rates will affect the value of your investment. If the duration is 5 years, then if interest rates go up by 1%, you lose 5% of the value of your investment. If interest rates go down by 2%, you'll get an extra 10% return. So changes in interest rates have a dramatic effect on a fund with a duration of 15 years and a tiny effect on a fund with a duration of 1 year.
But even if interest rates go up by 1% and you lose 5% of the value of your fund, you don't feel that 5% loss because some of it is offset by the yield of the fund. If the yield is 3% and you lose 5%, you really only lost 2%. Not nearly as bad.
# 3 Rising Rates Are Good for Long-term Bond Investors
Here is another critical principle of bond investing. You actually WANT interest rates to go up! Say what? Yes, that's right. Sure, you'll take an initial hit on the value of the bonds you currently own, but after that, your yield is then higher and eventually more than makes up for your initial loss. How long does it take to make up for it? Precisely the duration of the fund. So if you'll be investing in bonds for longer than the duration of your fund, get down on your knees and pray for higher interest rates. Now, you don't necessarily want the things that often occur with rising interest rates (rising inflation and/or a slowing economy), but as far as your bond investments go, a higher yield is a good thing.
Whitney clowning around with “the catch” in Honduras
# 4 Even When Rates Go Up, Bond Returns Aren't Hurt Much
In the last half of 2016, interest rates went up 1%. So what happened to bond returns in 2016? Every fund in the chart actually made money. In 2017 too. Even if you look at the “bad years”, what do you see? There were two years of losses in the last 7 years for Total Bond Market. In one year you lost 2.26% and in the other you lost 0.13%. Big whoop. That's what you're afraid of? You've got your fear sensor all screwed up. The stock market loses 10% pretty much every year and 20% every 3 years and you're cowering in fear about losing 2%?
# 5 If Worried About Rising Rates, Keep Durations Short
There is one fund in that chart that did lose a lot of money in 2013, the long-term bond fund. It lost almost 13% as interest rates rose a little over 1%. So what's the lesson to learn from that? If you're really worried about interest rates, keep your durations short. The short-term fund still had a positive return that year.
# 6 Bond Volatility Is Dramatically Less Than Stock Volatility
Finally, let's take a look at the range of returns seen in these bond funds. If you look at Total Bond Market, you'll see the returns ranged from -2.26% to 7.56%. In contrast, Total Stock Market had annual returns over this time period of -5.17% to 33.52%, and that's during what was mostly a bull market (it lost over 33% in 2008 and some sectors of the market lost nearly 80%). Adding bonds to your portfolio reduces volatility of the portfolio. Yes, it also decreases your expected returns, but if that helps you stay the course with your plan and still provides sufficient returns to meet your financial goals, that's a good thing.
Back to the Original Email
So, let's get back to the situation of our early retiree above. What should she do for an asset allocation? Should she avoid bonds all together and just invest it all in stocks? That seems foolhardy to run from bonds to stocks because you fear bond volatility because stock volatility is so much higher.
Should she leave it all in cash to ensure she loses no principal? In reality, cash is simply a very short term bond. The shorter the term, the less principal fluctuation you will see but the lower the yield. At the time of publication (several months after most of this post was written), the Vanguard Prime MMF is paying 1.97%, the Vanguard Short Term Corporate Bond Index Fund is paying 2.26%, the Vanguard Intermediate-Term Corporate Bond Index Fund is paying 2.76%, and the Vanguard Long-Term Corporate Bond Index Fund is paying 3.61%.
You cannot choose which of those will be the best investment for you over a given time period without a working crystal ball. If interest rates rise minimally, stay the same, or go down, you will wish you were in the longest term fund possible. If they go up dramatically, you will wish you were in cash.
In my opinion, the best thing to do is simply to pick something reasonable (usually a short to intermediate-term fund), stick with it for the long term, rebalance every year or two back to the original static asset allocation, and quit worrying about something you cannot control.
What do you think? What is the best approach to managing interest rate risk in your portfolio? Comment below!
Even in a low interest rate world bonds still do their job and smooth the ride. And of course there are going to be years where they out preform stocks. However I think there is little chance that there will be any time period of greater then 5-10 years where they will beat stocks. So for the investor with a long horizon it is hard to justify the opportunity cost just to lower volatility.
In fact this is a great time to be a young investor compared to our parents who had to deal with double digit mortgage interest.
Thanks for the reminder!
Overall great information and clarity.
After reflecting for a short time I would like to back peddle a little. I really have no idea if bonds or stocks will out preform. I think it is less likely to be bonds but what do I know. I am just a doctor not an economist. (Even they seem not to know)
You seem to be arguing about “why invest in bonds if I expect higher returns from stocks?” That’s a great question, but not the one this post was written about. This one was though:
https://www.whitecoatinvestor.com/why-bother-with-bonds-a-review/
“However I think there is little chance that there will be any time period of greater then 5-10 years where they will beat stocks.”
oh lordosis, never cherry pick times.
go look at the lost decade and see how retirees felt about their bonds “outperforming”.
Peds- I ended up adding some bonds. 5% of my portfolio in face. I oddly thought of you as I clicked the button 🙂
WCI- I was not being clear. I can see why it came off that way. I guess why invest in bonds right now? I fully plan to use bonds as a significant part of my portfolio later in my investing career even if interest rates stay low. I just do not care about having a smoother ride right now. When I am less then 20 years from retirement I will be adding in a more significant percentage.
Three reasons:
# 1 You might not have the tolerance of a more volatile portfolio
# 2 Bonds may outperform stocks even over long periods of time
# 3 Bonds perform differently than stocks and can zig when stocks zag and provide the opportunity to buy stocks low by rebalancing
Those are the arguments, but only you can decide on your stock to bond ratio. I’d caution you to err on the conservative side until you go through your first big bear market though. I knew lots of people who overestimated their risk tolerance and ended up selling low in 2008. Big talkers about 100% stock portfolios in 2007 weren’t talking so big in March 2009.
I’m having trouble understanding your point on #3. Say I am entering retirement with a long term bond fund with a duration of 20 years and the current 30 year bond yield is a little under 3%. If interest rates increase the paper value of that fund falls by 20x each % increase in the rate. The coupon will adjust very slowly because only (under) 3% of the original value is becoming available each year for reinvestment. The situation is even worse if I have to withdraw funds because I’m retired. If I’m still working and adding funds I know that the ultimate return from a bond is the current coupon while an equity portfolio folio return should be the dividend yield (a little under 2% now) plus earnings growth rate (which only needs to be 1.5% to beat that long bond today). Why would a long bond investor welcome rising rates?
You seem to be arguing “why invest in bonds if I expect higher returns from stocks?” That’s a great question, but not the one this post was written about. If you’re going to be investing for 40 years and the duration of your bond fund is 20 years (which is a really long term bond fund), then you would be better off over 40 years if interest rates went up at any time in the first 20 years.
Hope that helps.
Why no discussion of CDs as part of ones bond portfolio.?
Basically if you find the best ones they yield more than risk equivalent treasuries and don’t have the same interest rate risk. They do have reinvestment risk of course.
For folks who want their bond allocation to tilt to safety CD yields seem like the way to do it these days.
CDs are a fine choice. Why not discussion in this post? Because it was about bonds, not CDs. You could have also asked “why not discussion of whole life insurance?” Because whole life insurance is not bonds. CDs aren’t bonds either.
Well, while CD’s are not technically bonds, they (currently) are a very valid and higher yielding substitute for high quality or government bonds of the same term. They also meet most if not all of the same purposes as bonds in ones asset allocation.
Whole life is not a valid substitute and does not meet the same purpose and is completely different.
I realize you were probably being sarcastic with the Whole Life reference, but my mention of CD’s was intended to complete the discussion around ones bond allocation and how in the current environment CD’s should really be part of ones decision process as part of their “bond” allocation.
I’m perfectly fine with you using CDs as a bond substitute and agree they have some benefits over bonds. But you asked why I didn’t discuss it in this post. If I discussed everything in every post, nobody would read any of them because they would all be too long. A blog post is not meant to stand on its own but to viewed as part of a large body of work. That’s why they were not included. CDs are NOT bonds, act differently when interest rates change, and this post was about bonds.
And I assure you there are plenty of people out there who think whole life insurance is a valid bond substitute. Like you, I disagree with them. So no, I wasn’t being sarcastic.
Buy CD’s if you need the cash in 6 – 12 months. However, and don’t doubt me on this, there is no substitute for bonds / US treasuries in a diversified portfolio.
One nice thing about treasuries is they generally climb and sometimes quite sharply when the market drops. A CD won’t do that.
I want to say it was Charlie Munger, of Berkshire Hathaway fame, who stated the typical suggested Stocks\Bonds portfolio reflecting your age was a bad idea. E.G-turn 60 and you should be 60-40, turn 70 and you should be 70% bonds-30% stocks.
Should stay mostly in Stocks or pretty decent risk of outliving your retirement savings. Bonds smooth the ride, but most investors need some of the hills for better returns after inflation. Returns posted in the table indicative of the recent performance in bonds are probably pre-inflation.
Cannot remember if you reviewed the following book, “The 7 Most Important Equations for Your Retirement” but it had a lot of helpful information, to include how likely a person was to live X years after reaching certain ages. A lot of it depends on genetics (See Keith Richards) but some of it depends on personal habits\choices.
The one thing I don’t want to do is build my portfolio\retirement spending based on the idea I’m only going to make it to 75.
https://www.marketwatch.com/story/7-equations-to-build-a-secure-retirement-2012-06-27
There is certainly an argument for high stock:bond ratios in retirement, even an increasing ratio. But Buffett/Munger have always come down on the “all stocks all the time” side of the fence. I think he even recommend his widow have 90% stocks and 10% cash.
Yes, the table is nominal returns, not real returns.
Funny how no one in the comments section cares about the question I wrote the post about. They just want to talk about:
Bonds vs CDs or
Bonds vs Stocks
or whatever. Yes, they’re important questions addressed elsewhere on WCI many times.
Kind of thought you proved your point that one shouldn’t fear rising interest rates.
Hoped to add to the discussion versus refuting your point.
I’ve got more than one friend who had a “high risk tolerance” who went to cash several years back and missed out on the subsequent returns.
Guess the main point is to have a written down Investment Plan and stick to it. Whether it’s 5% bonds or 40% or higher, came up with a plan for a reason.
And Rising Interest rates are no reason to avoid bonds, especially with all of the varied options available for bond purchases these days. Think the days of the Govt mailing you a savings bond for you to store are long gone.
We just cashed the only savings bond we ever owned. It was given to my wife and we had it for 23 years from date of issuance. What a pain that was to cash.
I tried to discuss it as the premise of your post was that people are afraid of rising rates yet they should still invest in bonds anyway.
CDs are a way to accomplish the goal in a simple easy to understand way that does not have the same kind of interest rate risk and is a tool people can use who are concerned about rising rates.
Maybe I just did not make the point as clear as I needed to.
No, my premise is that if bonds are right for your portfolio, they’re not now somehow wrong because rates may go up.
If bonds aren’t right, because CDs are or because you want a 100% stock portfolio or whatever, then you should skip a post about bonds.
With regards to rising interest rates, CDs are nice in that they don’t lose value. But there is also a delay before your yield goes up that doesn’t happen with a bond fund.
“Age in bonds.” I suppose we humans like to make things more complicated than they ought to be. I think this lengthy bull run can also skew one’s perspective, too.
VBLTX avg duration 15 years avg yield 3.0%
If rates rise 1% the NAV drops around 11%. I’m still earning 3.0% on the bonds already in the fund. That doesn’t change if rates rise. only new bonds give me the higher rate. That might amount to only 4% of the total fund as average maturity is 24 years. So if 96% of the bonds are yielding 3% and the new bonds are @ 4% my blended return is only up to 3.04%. How is the increasing coupon income compensating for loss in bond principal?
No, that’s not right at all. Those bonds now have a higher yield. The NAV drops until the old bonds have the same yield as the new bonds you could purchase.
Oh, can I live on your planet? Where somebody can buy a bond at 2% , then the next day rates go to 3% , and they will let me return my 2% bond to get a 3% bond. Must be nice.
That would mean all outstanding Treasury debt would reset to market rates stat if rates rose!
I don’t think you’re understanding the math. Let’s say you have a $100 2% bond with a 5 year duration. The next day rates go to 3%. Your bond is now worth $95, but its yield is 3%. The coupon is still 2%, but the yield is 3%. You lost $5, but you’re now earning just under $3/year instead of $2/year. So yes, your yield rises. But it does so at the cost of some principal.
The coupon stays the same @ 2%. When said bond matures you get par $100 not $95. Just if you want to sell it before maturation then you’ll have to realize a cap loss due to prevailing market rates. The 2% bond has to compete with the higher yields. Hence the seller has to accept a discounted bid to compensate the new buyer.
You see, bond funds have had a structural tailwind for decades enjoying the kicker of capital appreciation along with a yield. When the secular trend turns these no cost bond funds are going to get scorched. Say the first 1 % rise spooks the savvy ones who just saw 2 years of income go up in smoke and they bail. These bond funds have no cash set aside. They will be forced to sell something to meet redemptions probably incurring a cap loss. A big whale like VBTLX will likely move the market downward. NAV drops further more get spooked, rinse, repeat.
There is a way for a fund to make money in a bond bear but it won’t do it for the fees Vanguard charges.
Oh my goodness you’re nuts if you think a 1% rise in rates is going to spook the masses out of the Vanguard Total Bond Market Index Fund. History proves I’m right. What history you ask? In the last 20 years the interest rate on the 10 year treasury went up at least 1% on 10 different occasions:
https://www.macrotrends.net/2016/10-year-treasury-bond-rate-yield-chart
I don’t recall seeing people pile out of TBM on any of those occasions. Heck, they didn’t even really pile out of bonds in general as can be seen in the second chart here:
https://www.philstockworld.com/2019/06/09/recessionary-panic-eurodollars-soar-to-levels-last-seen-during-the-european-financial-crisis-amid-record-bond-inflows/
The Vanguard fund today reports it has $5,379,114,743 in cash set aside. That’s right. $5 Billion. Does that sound like “no cash” to you? It sure doesn’t to me. Now granted this is a huge fund and $5 Billion is only about 2% of its assets, but there is certainly plenty there to make distributions for some people who get “spooked” when bonds act like bonds. And if they need more cash…guess what? 63% of the fund is in treasuries which are probably the most liquid investment out there. $505 Billion in treasuries is traded every day. Selling another 2% of the fund in a single day probably isn’t going to have a huge effect on the price.
Honestly you sound like a misguided financial advisor who is pushing people into high expense ratio loaded mutual funds thinking you’re doing them a favor. I mean you’re clearly wrong as I’ve shown above, but it isn’t clear to me if you are deliberately lying or simply ignorant on this topic. Neither looks very good though.
Bonnie is correct. The fixed $2 interest return (2% on the original $100 bond) remains the same regardless of the bond price.
If the bond price went to $95, the $2 annual interest would be a 2.1% annual interest rate ($2/$95=2.1%) if someone bought the bond for $95. I don’t understand where you get a 3% interest rate on a $2 interest return bond. My understanding is that bonds pay a set dollar amount, in this case $2/year, not a set % of the current bond price.
A $2 annual interest return would equate to a 3% annual return if the $100 bond price paying $2 annual interest went down to about $67 ($2/$67=2.99%).
I’m not a bond expert so please correct me if I’m wrong & why my logic is not correct as I was just going by the numbers you provided.
Bill
Yes, the $2 coupon is fixed, but the YIELD is not.
If we’re really going to get into the details, we also need to get really specific about whether we’re talking about bond funds or individual bonds too as there are slight differences.
Could you go more into details please? I can’t quite grasp this concept. Are we talking about a fund or individual bonds? How do the yields go up? Are these fixed or variable coupon rates?
Sometimes I’m talking about bonds and sometimes I’m talking about bond funds. Which would you like to talk about?
Do you understand the difference between:
the coupon (the original yield when the bond was issued)
the current yield
the value of the bond and
the total return of the bond?
For this example, let’s talk about a simple bond.
If interest rates go down, investors can no longer buy a bond with a yield equal to the coupon on your bond. So your bond becomes more valuable. As your bond becomes more valuable, its yield falls until it is equal to the coupon of a bond that can currently be purchased of the same maturity as what is now left on your bond. Does that make sense to you? The coupon hasn’t changed, but the yield has.
Hope that helps.
Always listen to the wise words of Bogle, “AGE IN BONDS”
No way. I’m only 40 and early in my accumulation phase. I’m 90/10 (stocks:bonds) and only plan to increase bond allocation 5% every 5 years so that I’ll be 70/30 at age 60. Bogle may have been right about a lot of things, but I don’t think this was one of them.
I have a hard time understanding how fixed asset allocations over your investment horizon without yearly assessment makes any sense. At age 50 how do you know 80/10 will be right for you?
We were in our early accumulation phase exactly 10 years ago (age 36) and had a 100% equity with emergency fund in cash. However, I have reassessed yearly what we will need during retirement and our risk tolerance. In those 10 years our equity/bond portfolio has grown to 3 million (not including home and investment properties). By your approach we should still be 90/10. But that would subject our portfolio to a level of risk that is just not acceptable to me at this stage based on our goals. Our goal retirement/FI age is 52-55, at our current 50:50 ratio if I receive a 7% return from my equities and a 2% from my bond allocation in 10 years we will still be at 6.5 million and more than enough to retire/be FI based on our projected financial needs.
I am of the belief risk should be adjusted to ones goals and probability of reaching those goals. For someone like Buffets wife, staying 90:10 makes sense as in the long run she will outperform. But it is easy to do that when you only need a small fraction of your portfolio to actually live on and a 40% decline in your portfolio will not impact your standard of living.
If tomorrow the market crashed 40% I would reassess my allocation and risk and re-run the numbers. My optimal ratio may change in that situation to maybe 60-80% equities or stay 50:50 after rebalancing.
The main point I am trying to get across is risk tolerance should reflect your goals and where your portfolio stands relative to those goals.
Jim, thank you for all the advice and support your blog has provided over those 10 years. Our net worth was around $400,000 when I started tracking it exactly 10 years ago and is now around 5.5 million.
To all the young docs out there knowledge is power and the only person who is 100% vested in your financial success is you!
Congrats on your success!
Had to laugh at the Eulogy of the 60/40 portfolio (no doubt a portfolio better than yours) at another website I read
https://awealthofcommonsense.com/2019/10/a-eulogy-for-the-60-40-portfolio/
Ben Carlson from A Wealth of Common Sense is an excellent resource and a wise financial thinker! Going to read this one now; thanks for recommending it 🙂
would nt argue with bogle-has been right about almost everything including intl stocks
Jim, I notice you mentioned toward the end of your post that it makes the most sense these days to choose a short- or intermediate-term bond. This makes me question the common conventional wisdom (at least in Bogleheads circles) to invest in Vanguard’s Total Bond Market Index Fund (VBTLX), which I do often, because it encompasses so much more than simply short-to-intermediate. Would it be smarter not to invest in VBTLX for this reason? Thank you kindly.
TBM is an intermediate fund, so that would qualify as a reasonable choice in my book. Other reasonable choices include:
ST Bond index
ST Corporate Fund
ST Treasury Fund
IT Bond Index
IT Corporate Fund
IT Treasury Fund
All fine.