I had a request recently for a post on bonds.

Q.

I have been reading a ton on your site and some of the investing books you recommended and much of the emphasis is on the equity side of investing. Would you consider a post on bond value fluctuations? I remember from some of your posts mentioning the good bond returns in 2008. Are there “seasons” where bond returns are higher than their bottom of the barrel returns now? Is the bond market ready for a increase in yield?

A.

I've written on bonds before, but not for quite a while. Two posts in particular, are essentially “ever-green” and well worth reading if you missed them the first time back in 2011. In this “back to basics” post, I described bonds and how they work. In this one, I dispelled the myth that bonds are destined to underperform due to their (then current) low yields. There was a lot of fear that bonds were going to tank in 2011 due to the fact that interest rates “had to go up.” I don't want to say I'm a prophet, but, it's easy to see that bonds haven't had some massive bear market in the last 3 years. Vanguard's Total Bond Market Fund had the following returns:

  • 2011: 7.69%
  • 2012: 4.15%
  • 2013: -2.15%
  • 2014 YTD as of October 27th when I wrote this: 5.33%

Everything I wrote in those two posts still applies in our current interest rate environment. Bloggers and book authors don't often write a lot about bonds, simply because they can be kind of boring. But boring investing is often good investing, so I'm going to write out a few of the thoughts I've been having about bonds in the last year.

Purposes of Bonds

There are several good reasons to include bonds in your portfolio. The first is for diversification. They are different from stocks and perform differently at different times. It's best not to put all your eggs in one basket. While historically stocks have outperformed bonds in the long run, the long run may be longer than your investment horizon, and besides, there is no guarantee that stocks will outperform in the future, even over a very long time period.

Second, bonds moderate the volatility of the portfolio. Despite their best efforts, many investors simply cannot tolerate a super volatile portfolio. It is better to have a portfolio with a lower expected return than to ever “crack” in a bear market and sell your stocks while they're down. Do that even once in your investing career and you would have been better off having a much less aggressive portfolio.

Third, some people simply don't need to take a lot of equity risk. If you inherit $2 Million at age 30, or if you've got enough money that you can fund your retirement at a 2% withdrawal rate, you simply don't need to take the risks of someone who really needs some growth out of their money. A bond-heavy portfolio could be completely appropriate for you.

Fourth, although stocks (and real estate) are generally thought to help protect from inflation, at least in the long run, only bonds can actually be indexed to inflation. I bonds and TIPS can perform an important inflation protection role in the portfolio.

My Crystal Ball is Cloudy

The doc who emailed me wondered if “the bond market is ready for an increase in yield?” What he really means is, “Are interest rates going to go up, and if so, when, and by how much?” When you rephrase the question like that, it's easy to see how silly it is. Like you, I have no idea what the answer is. Neither does anybody else. Make sure you have an investing plan that is highly likely to reach your goals no matter what happens with interest rates in the short run and in the long run.

One possibility is that interest rates return rapidly to historical norms, or even overshoot them. I can't believe it's only been a few years since I could get 5.25% in a money market fund that has paid me 0.01% for the last several years. That's not necessarily a bad thing for the long term investor. As I gradually move from being a borrower to being an investor, I'm all for real interest rates going up. It doesn't do me any good for them to go up if inflation goes right up with them, but if we can keep inflation at 2% and give me 5% on short term money and 7% on long term money, I'm all for it. Sure, I'll take a bit of a hit on the interest rate change (remember as yield goes up, bond prices fall), but I'll be better off within a few years for having taken it.

Another possibility is that we muddle along for years, or even decades, at these low interest rates. If that's the case, “staying short” in duration/maturity on your bonds (so you don't get hurt too badly if rates rise) is going to cost you 1-3% in returns on the fixed income side of your portfolio. Since I have no idea, I'm just going to continue following my “know-nothing” fixed income plan. Long term readers will remember that I have 10% of my portfolio invested in the TSP G Fund (no interest rate risk), 10% in the Schwab TIPS Fund in my 401(k) (provides inflation protection, but carries some interest rate risk), and 5% in Peer to Peer Loans (minimal interest rate risk, but massive credit risk.) It seems to have worked just fine for the last decade (3 years for the P2P loans) so I'm going to try it again. I suggest you stick with your well-designed, reasonable plan as well, whatever it might be.

Bonds Do Have “Good Seasons”

Although I don't know when they are going to be, bonds do have good times just like equities do. In fact, over the last 30 years or so, as interest rates have gradually trended down, bonds have had a long run of good times. For instance, Vanguard's Short Term Corporate Bond fund has returns of 6.5% over the last 32 years, the High-Yield fund has returns of 8.8% over the last 36 years, and Long Term Treasuries have had returns of 7.96% over the last 28 years. I don't expect that going forward (remember the best predictor of future bond returns for high quality bonds is the current yield, just 0.4-4% these days) but it is quite likely that bonds will perform quite well at times when stocks do poorly. In the tech bust, the Total Bond Market Fund (TBM) had returns of 8-12% per year and in 2008, even with lower interest rates, the long term treasury fund returned 24% while stocks lost a third of their value.

Still Hard To Get Excited About Bonds

Perhaps it is the fact that this bull market is now into its sixth year, but I confess I still wonder even about the small percentage of my portfolio I have in bonds. I don't need any of my retirement money for at least 10-15 years, and I probably won't need some of it for 50 years. My TIPS are basically promising a 0% return after inflation and the G fund is only yielding 2%, or about the same given current inflation. I have a solid emergency fund, plenty of cash on the side earmarked for various things from my next car to my tax bill in April, and a proven ability to tolerate severe portfolio fluctuations. Should I really have long-term money in investments with an expected real return of 0%? Perhaps not. But as I often say, it matters far more that you follow a reasonable plan than what reasonable plan you follow, so I'll stay the course for now. I certainly haven't regretted it in the past.

Comparing Bond Classes

Larry Swedroe uses a guideline that you should be paid 20 basis points for every additional year of maturity in order for it to be worth taking that interest rate risk. Using that guideline, we can compare the following Vanguard funds with cash, the TSP G Fund (my preferred “nominal bond” holding), and each other.

Fund Duration Yield Vs Bonds Vs Cash Vs G Fund
Cash (Ally Bank) 0 years      0.90% N/A N/A N/A
G Fund 0 years 2.00% N/A N/A N/A
Short Term Treasury 2.6 years 0.47% N/A -0.17% -0.59%
Int Term Treasury 6.1 years 1.48% 0.29% 0.10% -0.09%
Long Term Treasury 25.8 years 2.59% 0.06% 0.07% 0.02%
Short Term Corporate 3.0 years 1.61% N/A 0.24% -0.13%
Int Term Corporate 7.5 years 2.57% 0.21% 0.22% 0.08%
Long Term Corporate 23.9 years 4.36% 0.11% 0.14% 0.10%

The numbers in this chart represent the additional yield you get per year of extra duration over either the Vanguard bond fund with the next shortest duration, cash as represented by Ally Bank's FDIC insured savings account, or the G Fund. If the number is colored red, it is less than the 0.20% Swedroe recommends. If it is colored green, it is more.

As you can see, if you have access to the G fund, you aren't being adequately compensated to move your money into any other bond fund per Swedroe's rule. But even if your best cash option is a good online savings account, none of Vanguard's treasury funds are adequately compensating you for the interest rate risk. When comparing bonds strictly to bonds, you only get compensated to go out to the intermediate range, and not all the way to the long range bonds- i.e. Intermediate treasuries only look good when compared to short term treasuries. Corporate bonds look a little better. Moving to short term beats cash and moving to intermediate term beats cash and short term. Bottom line: If you prefer a more active bond strategy than my know nothing strategy, you still ought to be careful to leave a good cash option, and even then, perhaps stick with corporates of intermediate duration or less.

What about Munis?

Many docs in high tax brackets with a low ratio of tax-protected to taxable money have opted to use municipal bonds. Are they being compensated adequately for taking interest rate risk? Let's take a look.

Fund Duration Yield Vs Bonds Vs Cash
Tax Exempt MMF 0 Years      0.01% N/A N/A
Limited Term Muni 3.3 Years 0.76% N/A 0.23%
Int Term Muni 8.8 Years      1.63% 0.16% 0.18%
Long Term Muni 16.1 Years      2.30% 0.09% 0.14%

It would appear that with Munis, interest rate risk is worth running when compared to a tax-exempt MMF, at least out to the intermediate level. I also found it interesting that the LT muni fund has a dramatically shorter maturity (and duration) than the LT treasury and corporate funds.

What about TIPS and I Bonds?

TIPS yields also climb with longer duration. However, interest rate risk isn't such a big deal with TIPS as with nominal bonds. Interest rates often (but not always) go up because inflation goes up. If the TIPS are giving you 1% real, then as long as interest rates and inflation climb together, you should make up for a lot of the loss in value from rising interest rates with an increase in the inflation component of the bonds. Accordingly, the TIPS yield curve is much more flat, with the real yield on a 5 year TIPS (0.35% real) being just 0.53% less than the real yield on a 30 year TIPS (0.88% real). The current real rate on I Bonds (0.10% real) is also pretty disappointing these days, but most people don't really have a choice between the two given their personal portfolio situations. (If you have bonds in taxable, I bonds are preferred, if in tax-protected, TIPS are preferred.  Not to mention you can only buy a few I bonds per year.)

What about Riskier Bond Options?

There are other options for your fixed income, although many of these strategies are appropriately derided as “chasing yield.” These include junk bonds, Peer to Peer Loans, Hard Money Lending, and other strategies.  If you're going to invest in junk bonds, I suggest Vanguard's High Yield Corporate fund, which has a bit of a hedge fund strategy- selecting the very best of the junk bonds that are less likely to default, but still have to be sold by institutional investors who aren't allowed to hold junk bonds by investment policy. I've had quite a bit of success investing in Peer to Peer Loans (returns of around 12% over the last 2-3 years), but do your homework to understand the very real downsides of this asset class. Hard Money Lending is also a way to increase risk in an effort to earn a higher return. Diversification can be a real issue with this asset class. There are other risky options out there for your fixed income dollars, but I would suggest limiting the percentage of your portfolio invested in any of these to just 5 or 10%. Traditional bonds are traditional for a reason.

I hope you find some of that rambling about bonds, and especially the links to the more broadly written overview posts, helpful. What is your bond allocation and why? Are there any circumstances which call for you to change it? Comment below!