Game Over

Jonathan Clements

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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