Don’t forget bonds

There is an interesting dichotomy at play today in retail investment circles.  Individual (i.e. retail) investors are clamouring for bonds and bond funds since the wounds from the 2007-09 bear market remain fresh while bonds have been a haven.  Financial advisors – already an equity oriented contingent – are increasingly buying the industry’s pitch to ditch bonds in favour of equities.  But some context is needed before making any big shifts.

Industry argument in historical context

The industry argument goes something like this.  Dividend yields on stocks are now about the same as or more than the yield to maturity on bonds.  Rates are bound to rise as the economy regains more solid footing, which will push bond prices down.  Accordingly, buy stocks since they’re the better relative value and likely to be superior long-term performers.

This is an intuitive argument but there are good reasons to step back for a moment before jumping head first into stocks.  I wrote about the Fed model several years ago in an investment strategy report.  The Fed Model, popularized by former Federal Reserve Chairman Alan Greenspan, compares earnings yields on stocks (i.e. the P/E ratio inverted) with U.S. Treasury bond yields.  In the December 2003 Strategy Update – see pages 1 and 2 of the report – I illustrated this model from 1926 through the fall of 2003.  The graph looks nearly identical when using dividend yield rather than earnings yield.

The chart reveals that yields on stocks stayed higher than bond yields for four decades.  It wasn’t until the 1960s that bond yields surpassed equity yields on a sustained basis.  Considering the full context of history, it seems imprudent to abandon bonds to jump head-first into stocks because a situation that prevailed for 40 years has resumed only recently.

At the same time, investors’ infatuation with bonds at the expense of prudent stock allocations seems too reactive to the 2007-09 bear market.  In other words, both advisors and investors have to come off of the extremes.

Bonds expensive but necessary

My partners at HighView and I agree that bonds are expensive today with annualized yields hovering around 3%.  And while we don’t view stocks as being dirt cheap in general, nor are they grossly overvalued.  As I articulated in this March 2007 article, the role of bonds remains important in the context of portfolios.  While bonds have their risks and yields are low, they continue to be important for income generation, capital preservation and portfolio diversification.

While bond yields are relatively low at around 3% annually (broad market), bonds remain a source of stable income.  The main fear of buying bonds today is out of concern for rising interest rates.  However, a laddered structure and selected exposure to credit risk can combine to offer effective protection against this risk.

Short ladder has low duration risk

A simple ladder would see, for instance, a portfolio’s bond allocation split into five equal investments in bonds with maturities ranging from 1 year to 5 years.  Since duration – a measure of interest rate risk – is short with a 5-year ladder interest rate risk is relatively low.  Every year there is a bond maturing with this structure which facilitates, in a rising rate environment, the reinvestment of matured bonds at lower prices and higher yields.

Current market rates indicate that a short ladder can produce a current yield-to-maturity (YTM) approaching 2.5% annually.  For example, looking the Claymore 1-5 Year Laddered Government Bond ETF and the Claymore 1-5 Year Laddered Corporate Bond ETF, a 50/50 split would offer a YTM of 2.4% and a duration of 2.9 years.

The short duration will limit potential damage in the even of rising yields.  For instance, if short yields shoot up 200 basis points over the course of a year, this kind of ladder would produce a net loss of 3.4%.  If they rise 400 basis points, losses would still be in the single digits – similar to what happened during the worst bond bear market in North American history.

Limiting losses facilitates quicker recovery

While the typical bond bear market results in single-digit losses (with the worst in the low-teens), the average stock bear market sees a full 33% sliced from stock prices, spending two to three years under water.  So, when it comes to limiting shorter-term losses and volatility, bonds continue to play an important role – as they did in the 2007-09 bear market – to preserve capital.  But perhaps the most striking example of the importance of bonds comes from the Great Depression.

From the above table, we see that a portfolio of 100% U.S. stocks (in USD) was under water for more than 15 years, a dozen of which was spent recovering from the bottom.  A mere 25% allocation to U.S. bonds (in USD) cuts the time spent in the red by more than half.  And a more common 60% stocks, 40% bonds made the trip from top to bottom to recovery barely over 6 years.

Diversification addresses price risk

When an asset class gets expensive, diversification can play a role in reducing valuation risk.  Diversifying oustide of bonds – into stocks and cash for instance – can offer protection should bonds enter a weaker period.  Similarly, diversifying outside of the stock market worked remarkably well to limit 2007-09 bear market losses.  Less often, diversifying within an asset class can bear market risk.

Diversifying within the class of bonds means holding a mix of government, provincial, corporate and high yield bonds.  This can be accomplished by investing in a single, broadly diversified bond mandate or by obtaining more focused exposure to each of these bond components.  Within the government segment, an allocation to real return bonds (RRBs) may be warranted as a long-term inflation hedge.  But since RRBs in Canada are all long-duration issues, an offsetting allocation to short-term bonds to control interest rate risk may be warranted.

Many decades ago, Benjamin Graham noted that even the most enterprising (i.e. hands-on) investors should have a minimum of 25% in stocks but never more than 75%.  The inherent uncertainties of investing, he reasoned, called for an absolute minimum amount of asset class diversification.  Graham’s advice is nearly 60 years old but it remains as relevant today as it’s ever been.  And since short-term movements are inheritantly uncertain, Graham’s excellent advice will serve to pull advisors and investors from their extreme postures.