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.
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.
# 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!