A ‘New Era’ for Bonds?

The Wall Street Journal recently published an article titled How You Can Survive a New Era in the Bond Market.  The article suggests that investors adjust their bond allocations to tilt more towards high-yield (aka junk) bonds (both corporate and municipal) and global bonds, which tend to yield more than U.S. bonds.  This advice resonates with an Op Ed by Burton Malkiel, famed author of A Random Walk Down Wall Street, at the end of 2013.

The case against bonds is straightforward.  The best estimate for the expected future return from bonds is their current yield.  If you hold a bond until maturity, your total return will be very close to the current yield.  There are nuances to this rule.  With high-yield bonds, you should expect a total return that is a bit less than the current yield due to the fact that some of these bonds will probably end in default.  With bond funds, you don’t necessarily end up holding individual bonds until maturity, so the correspondence between current yield and expected return is a bit weaker.  Nonetheless, with current yields as low as they are, bond investors should not expect attractive returns from most bond classes.

There is no question that investors with low risk tolerance are faced with unpleasant choices about where to invest.  The ‘risk free’ rate of return is essentially zero and is certainly below the rate of inflation.  The WSJ article, by suggesting a replacement of U.S. government bonds or an aggregate bond index with higher-yield alternatives such as junk bonds and emerging market bonds, seems to ignore the fact that this type of shift may make the income-oriented portion of investors’ portfolios more volatile.  If one were to pursue this strategy, substantial care would be required.  As low-yield bonds are replaced with higher-yielding bonds or equities, some other higher-risk portion of the portfolio would need to be trimmed back.  In addition, changing a portfolio’s mix of fixed income assets also tends to change the portfolio’s sensitivity to changes in interest rates.

To illustrate this issue, I wanted to see how one might change the allocation of a basic 50% stock/50% bond portfolio so that the fixed-income portion of the portfolio had higher yield but without changing either the total portfolio risk level or the portfolio’s exposure to interest rates.  I also added the constraint that any changes to the portfolio not change the portfolio’s total expected return.  The analysis of the various portfolio choices was performed using Quantext Portfolio Planner, a portfolio planning tool that I designed.  I represented each asset class using an ETF.  The results of the analysis are shown below.

Chart_4Feb2014

Portfolio 1 is simply 50% allocated to an S&P500 stock fund and 50% allocated to an aggregate bond index (AGG).  AGG has a yield of 2.3% and, as the Wall Street Journal article suggests, this is probably a decent estimate of the expected future return.  Quantext Portfolio Planner estimates the expected total return for AGG to be 2.4%.

In selecting a broader universe of asset classes from which to choose, I added one stock fund (IWM) to represent small cap stocks.  This specific addition is because small cap stock indexes tend to rise when interest rates rise.  In experimenting with changing the fixed income allocations, it is useful to allow a higher allocation to small cap stocks to offset any potential increased exposure to rising rates.  Fixed income assets tend to decline with rising rates.

I included two very short-term bond asset classes (SHY and BIL), which have lower yields than AGG, as well as a number of higher-yield bond classes.

For Portfolio 2, I specified that all of the allocation to stocks would come from the S&P500 (no small cap exposure).  I ran through a wide range of possible allocations with a goal of maximizing the yield of the fixed income allocations, while maintaining the same level of total portfolio risk and interest rate exposure as the original portfolio.  I also limited allocations to high-yield corporate bonds and high-yield municipal bonds to 20% of the portfolio each.  With Portfolio 2, the yield of the fixed income portion of the portfolio is 3.4%, boosting the projected yield.  The total projected portfolio yield has also increased.  To keep the risk level of this portfolio equal to the original 50% SPY / 50% AGG portfolio, however, the equity allocation of this portfolio is lower, with only 42% allocated to SPY.

For Portfolio 3, I allowed the model to choose allocations between small cap stocks (IWM) and large cap stocks (SPY), as well as varying the allocations to different classes of bonds.  In the resulting portfolio, the projected yield from the fixed income assets has risen to 3.8% (as compared to 2.3% in Portfolio 1).  The resulting portfolio yield is 3%.  The allocation to equities in this portfolio is only 29.5%.

These three portfolios provide an important demonstration.  Simply shifting a portfolio’s bond allocation towards higher-yielding asset classes is potentially dangerous.  Higher-yield bond classes also tend to have higher risk and, quite often, increase a portfolio’s sensitivity to interest rates.  Even undertaken carefully, trying to boost the expected return from the fixed income portion of a portfolio has the potential to change a number of characteristics and exposures in a portfolio.  There will be very few investors who would ever hold a portfolio with a 40% allocation to high-yield bonds (Portfolio 3) because such a portfolio is highly exposed to default risk—the risk that companies or municipalities will go bankrupt. Default rates have been low in recent years, but the rate of default for municipal bonds has risen since the financial crisis and high-yield municipal bonds, those with lower credit ratings, are where these defaults are most likely to occur.  In the corporate high-yield market, defaults are also low but default rates can increase rapidly in times of economic stress.

The conclusion to be drawn from this exercise is that there is no free lunch from simply shifting around the fixed income allocations in a portfolio.  You can boost yield by shifting to higher-risk bonds, but then you must also reduce or otherwise alter the allocation to equities if you want to keep your portfolio’s risk level and interest rate exposure the same.  I agree with many of the experts cited in the Wall Street Journal article that traditional bond allocations can be improved upon, but considerable caution is required.

Author’s disclosure: I own HYD and HYG.

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