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Game Over

Jonathan Clements  |  October 10, 2020

LET’S START WITH the obvious: If you buy high-quality bonds today, you’ll collect very little yield—and there’s an excellent chance you’ll lose money once inflation and taxes are figured in.

Take Vanguard Total Bond Market ETF, which aims to track U.S. high-quality taxable bonds. It yields some 1.2%, which is below the 1.7% expected annual inflation rate for the next 10 years, and the amount you pocket will be even less after deducting taxes. In fact, high-quality bond yields are so low that investors can now earn more income by buying the broad U.S. stock market, though that, of course, would involve considerably more risk.

The bottom line: For now—and probably for the foreseeable future—bonds can’t play their No. 1 traditional role, which is to provide a healthy stream of income. That game is over, with big implications for how we structure our portfolios and how we think about our bond holdings.

While we can no longer get significant income from high-quality bonds, they could play two other potential roles in a portfolio. Role No. 2: Act as a diversifier for stocks, providing offsetting gains when stocks are suffering.

Vanguard Total Bond Market ETF—which has 59% in U.S. government bonds—has a slight negative correlation with Vanguard Total Stock Market ETF, which means it should provide modest gains when the U.S. stock market next tanks. Want even better bear market protection? As we were reminded earlier this year, the surest strategy is to focus solely on Treasury bonds.

But buying Treasurys as a diversifier for stocks creates a nasty dilemma. It isn’t simply that Treasury yields are tiny, with even 30-year bonds paying less than 1.6%. On top of that, if your goal is to have an investment that goes up sharply when stocks go down, you’ll need to head far out on the yield curve.

Let’s say you bought Vanguard Long-Term Treasury ETF. It has a duration of almost 19 years, which means it could soar 19% if interest rates dropped one percentage point during an economic slowdown—but you’d also lose 19% if interest rates head higher by one percentage point.

Not sure you could stomach that? You might go for something tamer, such as Vanguard Intermediate-Term Treasury ETF. It has a duration of five years, so you’re only looking at a 5% gain or loss on a one percentage point move in interest rates. Problem is, a 5% gain wouldn’t do much to salve your investment wounds if the economy slowed, stocks tumbled and interest rate fell by one percentage point.

Like everybody else, I have no idea where interest rates are headed from here, so there’s no point in playing market prognosticator. That said, we can think about short-term risk—and I’m not sure many of us would be happy with the gain vs. loss tradeoff offered by intermediate and long-term Treasurys, especially when the net result over the life of these bonds will be a negative after-tax, after-inflation return.

The upshot: We can’t expect bonds to fulfill their traditional income-generating role—and I’m not sure the tradeoff is all that attractive if we buy them as a diversifier for stocks. That leaves us with role No. 3: Hold bonds as a backup source of cash if it’s a bad time to sell stocks.

If that’s our reason for owning bonds, we might still stick with government securities—but instead of plunking for the long-term Treasurys that’ll potentially deliver big upside gains when stocks next suffer, we might go for short-term bonds. That way, we’re taking very little interest rate or credit risk, and thus—if we need cash from our portfolio—we can be confident our bonds should be worth pretty much what we paid, no matter what’s going on in the world.

In other words, I’d stop thinking of bonds as a source of yield or as a diversifier for stocks. Instead, think of them as way to generate cash if the stock market is in the toilet. How much should you have in short-term government bonds? It depends on three key factors:

  1. Whether you’re working or retired. As an emergency fund, those who are working might keep three-to-six months of living expenses in short-term government bonds or, alternatively, in super-safe cash investments like savings accounts and money market funds. If your job is at risk, go for the full six months. Meanwhile, if you’re retired or near retirement, you might calculate how much you need from your portfolio over the next five years and keep that sum in conservative investments.
  2. Whether you have big onetime expenses coming up in the next five years. Those expenses—your teenager’s college tuition, the money for the new roof, the down payment on a new house—should also be in short-term bonds or cash investments.
  3. How much risk you can tolerate. If you find stock market declines unnerving, you might keep additional money in short-term government bonds. How much more? It depends on how much you need in conservative investments to stay calm when the stock market next plummets.

The overriding goal: You should be able to look at your portfolio and say to yourself, “No matter what happens to my stocks in the short term, I’m happy to hang on to them, because I have the money I’ll need to spend in the near future sitting in safe investments.”

Suppose you’re retired, with five years of portfolio withdrawals in short-term government bonds and cash investments. You know that, if stocks plunge, you have five years before you’ll be compelled to sell stocks to buy groceries. That should be enough time for the stock market to recover.

That’s how I view the bonds in my portfolio. As someone near retirement age, I have enough in short-term government bonds to cover my expected expenses in the years ahead. That frees me up to invest the rest of my portfolio in stocks—and, fingers crossed, those stocks will deliver results that compensate for the wretchedly low return on my bonds.

Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include Pay It Forward, Not Exactly True and Seems So Easy

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Laura Bignami
Laura Bignami
6 months ago

Interesting article. I came to a similar conclusion, which would imply having a larger allocation to stocks. However how would you answer the criticism that in an efficient market all assets are priced efficiently relative to each other, so that if returns on bonds are expected to be negative, stocks returns should also be very low and perhaps negative, with considerably more risk?

Jonathan Clements
Jonathan Clements
6 months ago
Reply to  Laura Bignami

I do expect the next decade’s stock returns to be lower than the historical averages. But stocks are riskier than bonds, so it’s reasonable to expect that their real returns will be positive.

HannahKatz
HannahKatz
6 months ago

Curious how you feel about Corporate Bond funds like VICSX. Its returns have been well over inflation over 10, 5, 3 and 1 year periods. Or Intermediate Core Plus Bond funds like BCOIX. Same story. Do you expect these categories to produce below inflation returns in the future? BTW I always look forward to reading your column each Saturday morning – always packed with useful information.

Jonathan Clements
Jonathan Clements
6 months ago
Reply to  HannahKatz

Corporate bonds should fare better than Treasurys over the long haul, though I wouldn’t use historical performance as a guide to their likely absolute returns, because yields are now so much lower. The question we all need to ask is, “Why do I own bonds?” If you’re buying them to complement stocks, corporates don’t look like a compelling choice. Back in late February and early March, if you needed cash from your portfolio, you’d have been happy to sell Treasurys — but not corporate bonds, which sold off badly during the initial pandemic panic.

medhat
medhat
6 months ago

Or keep liquid cash needs in… cash. I have long had very (very) limited bond exposure for the reasons stated, or more specifically, for the risks stated. Having a cash cushion (in simple bank money market accounts) is my front line for what I term “operational expenses” of life, which also includes a bit for unexpected expenses. I read somewhere long ago that an additional way to access additional cash is a home equity line of credit, which I’ve also employed with notable satisfaction (I use it tied to the rare overdrafts from my cash account; just have to remember to repay the “loan” as to not incur significant interest). I’m not yet at a stage to tap investments for income, so the overwhelming rest of assets are in equity holdings. Given the market performance during my working career, this has proven (in hindsight) to have been a productive strategy. The appreciation has as expected far outstripped the performance of any other asset class, and my planned retirement strategy is to sell appreciated assets as needed with the intent to utilize the capital gains tax rate.

wtfwjtd
wtfwjtd
6 months ago

Excellent discussion Jonathan. Discussing today’s low bond yields is also an excellent time to point out that, for the portion of our portfolios that we have designated for bonds, “investing” in immediate income annuities and Social Security are much more attractive and practical options in today’s dismally low rate environment.

Also, for that portion of our portfolios earmarked for stocks, choosing a dividend-paying class to generate some current income should be high on our to-do list. For example, an S&P 500 ETF has a dividend yield of around 2%, and there are several other stock index ETF’s that have a similar or slightly higher yield. This gives one a better yield than bonds, with the added advantage of more favorable tax treatment for dividends. All you have to do is simply choose to have dividends paid out to you (rather than re-invested) and presto, you have a current stream of income without having to worry about selling anything in a down market. Sure, the underlying value of your stock holdings will fluctuate, but I view this as akin to buying a house or something similar; real estate values fluctuate all the time, up and down, and yet we rarely if ever lose any sleep over it. Buying a stock index fund is very similar, so why should we think about it any differently? I’ll assume this “risk” vs. the very real long-haul inflation risk of the low-paying long bond any day.

Liz
Liz
6 months ago

Great article, I’ve also been uncomfortable with the risk vs reward of bonds. My solution was to hold 7 years of expenses in money markets and multiple 5 year CD’s when I retired. The payback between 5 year and shorter duration rates was 19 months when I purchased. So long as I held the CD’s at least 19 months, I came out ahead even if I had to pay an early withdrawal penalty. Multiple CD’s of about one year’s spending each was to keep the penalty for early withdrawal low.

I’m selling stock index funds to support my spending when my invested net worth is within 10% of its all time high and living on cash or those CD’s when I’m below that threshold. Four years into early retirement and I haven’t needed the CD’s yet.

I look at Social Security as my long term bond, that and cash/CD’s balance the risk in my portfolio.

davebarnes
davebarnes
6 months ago

“retired, with five years of portfolio withdrawals in short-term government bonds and cash investments”
This is me, except we are at 7+ years.
The question that I have not answered is: what is the right/best number?

Langston Holland
Langston Holland
6 months ago
Reply to  davebarnes

I think the “+” in your 7+ years is very true. If/when we go through a bear market of that length, we’ll be cutting our spending relative to normal life quite a bit. So that’s a plus. 🙂

The right/best number is as always with us humans; strongly influenced by our emotional makeup, which tends to be a slowly moving target based on age, experience and events. That subjective aspect must be considered in addition to the numbers or there’s a chance we’ll screw it up and bail at the wrong time when the test comes. It’s the same concept as risk tolerance vs. risk capacity.

Here’s one of my favorite looks at prior crashes for the objective part of your decision. Personally, I think you’re sitting pretty.

Kevin Knox
Kevin Knox
6 months ago

A typically excellent and timely post Mr. Clements – thank you!

Not much to add except that at least for now FDIC and/or NCUA-insured short-term CDs from the top online banks and credit unions offer interest rates that while pitiful are still better than Treasuries all the way out to 10 years while being just as safe.

The 10K per person per year purchase limitation on iBonds may make them not worth the hassle for some, but their 1.06% coupon and built-in inflation protection plus not having to pay any taxes on them until redemption makes them far superior to short-term TIPS or nominal Treasuries of any duration.

Lastly I find Vanguard’s BSV to be a decent quasi-Treasury short-term fund. It’s 65% Treasuries and Agencies, the rest high-quality corporates, 2.9 years duration and has never had a losing year (so far). Perhaps money socked away in it will keep up with inflation over time, and that seems to be about as much as one can hope for.

Thanks again for not just this post but for being a beacon of clarity and sanity for so many years.

David Powell
David Powell
6 months ago
Reply to  Kevin Knox

+1 for I Bonds for all those reasons. They’re one part of savings for our transition to full retirement, to defer SS until 70

Mehul Gandhi
Mehul Gandhi
6 months ago

Thanks for the article. A few questions come to mind
1. Money continues to flow into bond funds despite these current negative features.
2. Did not see you mention tax free municipal bonds. How should one consider them in the current climate.

Jonathan Clements
Jonathan Clements
6 months ago
Reply to  Mehul Gandhi

If the key remaining role for bonds is as a backup source of cash, munis aren’t especially appealing. They got hammered during the initial weeks of the pandemic, while Treasurys rose sharply.

Market Map
Market Map
6 months ago

Research shows that an equity based index / fund representing the Large Cap value “attribute”, has sustained a “7%” annual income withdrawal ( inflation adjusted ), accompanied by terminal portfolio growth, through “sale of shares” regime ( dividends reinvested ) over seventy one 20 year “rolling” periods since 1932.

Realistically, there WERE periods when the income withdrawal and “return sequence” depleted the portfolio to “0” ( “failure”), yet when applying a simple tweak to the withdrawal rate, based on year end portfolio balance, those periods could be eliminated ( see charts 1 and 2 here https://tinyurl.com/y6key3v5 ).

Investment in low expense, modern, and well diversified large cap index funds representing the “value” attribute, can be used in this regard. Funds representative of the “dividend growth” attribute may also be considered, although the data set for div growth for historical testing, is more limited than the “value” attribute.

This is not to say that an investor HAS to take a “7%” income withdrawal, however, armed with this 80 plus years of evidence, an income investor may take a more “creative” and scientific approach towards harvesting income with the “unlimited upside” of large, stable quality companies, and not be beholden to duration assets’ ( bonds ) inevitable and gradually diminishing returns and “constricted upside”.
Sure one can deploy duration assets within a portfolio towards reducing “volatility”, yet they may want to use the benefit of their “negative correlation” strategically.

Einstein
Einstein
6 months ago

Jonathan, I’m wondering why not put some $ into a High Yield Fund, perhaps a more conservative one like Vanguard, as a middle ground, rather than a full jump into stocks?

Jonathan Clements
Jonathan Clements
6 months ago
Reply to  Einstein

As I see it, junk bonds are just an unhappy compromise between stocks and bonds. If you want higher returns, why not just take the money you wanted to put in junk bonds and instead split it between high-quality bonds and stocks? That should give a similar boost to your portfolio’s expected return, but without the high cost and opaqueness of junk-bond investing.

DAVID s NAFZIGER
DAVID s NAFZIGER
5 months ago

Great article……taking your thoughts and Warren Buffett’s on a retirement portfolio…..
95% placed into low cost S&P 5oo index fund and 5% in S.T. Treasury Fund ( both Vanguard Fund). After studying your article one would change the allocation 80% and 20%
or 85% and 15%
I am 75yo and moving into that portfolio.
Solves many problem….1) ultra low cost, 2)removes much of the interest rate and inflation risk, 3) very simple to manage by rebalancing.
Appreciate your thoughts…..

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