March 30, 2017

‘Go Fishing’ in the Calm Sea of Bonds

Sail Boat in a Sea of Bonds

Adding bonds to an all-stock portfolio can boost returns and lower volatility, especially in choppy markets. Bonds should be a small but important part of your gone-fishing portfolio allocation.

Creating a gone-fishing portfolio begins with a top-level asset allocation. For a typical 40-year-old investor, the percentage in stable fixed-income investments would be 14.6%. The remaining 85.4% would be allocated among appreciating equity investments.

Portfolio construction begins with the most basic allocation between investments that offer a greater chance of appreciation (stocks) and those that provide portfolio stability (bonds). These decisions are the most critical in determining the overall behavior of your portfolio returns.

In the stable asset classes, you loan a company money to be paid back at a fixed rate of interest. Examples include money market, certificates of deposit (CDs) and bonds. These asset classes are like the iron rods that support a sailing ship. They don’t make the ship go faster, but they do keep it from capsizing in a storm.

Investors approaching retirement should have at least five to seven years of their safe spending rate allocated to stability. For them, replenishing their allocation to stability when stocks are appreciating helps secure future years of spending.

In a more sophisticated portfolio, we would divide the allocation to stability into short money, U.S. bonds and foreign bonds. For a 14.6% stable allocation, we would put 3% in short money, 5.8% in U.S. bonds and 5.8% in foreign bonds.

Short money includes any fixed-income investment with a maturity date of two years or less, which includes money market accounts and many CDs. Short money investments are not paying a great rate of interest right now. But when interest rates rise, they will adjust quickly and be among the first investments to gain from the higher rates.

Many risk-averse investors put their money in a bank account or invest in CDs. But like any other investment, cash has its own set of risks. It is dangerous because the dollar can be devalued so the same number of dollars won’t buy as much as they used to. There are good reasons to hold cash, but holding too much for too long makes it harder to grow your assets and can jeopardize your financial goals.

The second asset class, U.S. bonds, generally pays a higher interest rate the longer their duration and the worse their credit quality. But longer term bonds drop more in value when interest rates rise. And bonds whose credit rating drops lose value too because of the chance of default.

Putting money in stable instruments because you want to reduce risk only to invest in high-yield junk bonds is counterproductive. So is increasing the term of a bond when interest rates are very low. We recommend higher quality short- and intermediate-term bonds. Invest a portion of your assets in stable investments, and if you want a higher return, put the money into appreciating assets.

Foreign bonds are the third stable asset class. They can balance domestic currency values and interest rates with what’s happening in the rest of the world. And they sometimes pay a higher interest rate. Foreign bonds also appreciate when the U.S. dollar is declining in value. Foreign bonds are subdivided into bonds in developed countries and bonds in the emerging markets. Like U.S. bonds, foreign bonds are categorized by quality and duration.

Over the long term, stocks outperform bonds and bonds outperform cash. Appreciating assets are essential to your portfolio. They are the engine of your retirement savings. Even in retirement, you will need enough appreciation to keep up with inflation, pay the taxes and still have some real return left over.

Fixed-income investments are much more stable than equity investments. On average, however, they only earn about 3% over inflation. With inflation at 4.5%, fixed-income investments should be paying about 7.5% on average. With the Federal Reserve holding interest rates low, fixed-income investments currently are earning below their historical averages.

But you aren’t adding bonds to your allocation for their return. You are doing it to keep a portion of your assets safe when the markets drop. And when they do, you will rebalance by selling some of these safe bond investments and putting the money back into the markets.

This means you aren’t all that concerned about bond yield. The appreciation side is your engine of growth. Put more money there if you want more appreciation. You also aren’t interested in yield curves, inefficiencies in the yield curves or whether or not we are in a rising interest rate environment. All these are important areas where a more sophisticated portfolio management could add value. But you are specifically trying not to watch these issues. You are trying to go fishing.

The good news is that you don’t have to eke every cent of yield out of your stable investments to meet your financial goals. You don’t need to invest in high-yield junk bonds so long as you have a healthy allocation to appreciating equities. As a result you could invest your entire allocation to stability in a single U.S. bond index fund.

For example, the Vanguard Total Bond Market Index ETF (BND) has a low expense ratio of 0.11% and includes investment-grade corporate, U.S. Treasury, mortgage-backed and asset-backed securities with an average duration of 5.2 years and an average maturity of 7.4 years. The current yield is 0.65%, and the fund represents more than 4,900 bonds.

BND is sufficient for your gone-fishing bond allocation, but any short or intermediate relatively high-quality bond mutual fund or ETF would meet your investment needs so long as the expense ratios are low. As a second bond fund, consider adding iShares Barclays TIPS Bond ETF (TIP). It also has a relatively low expense ratio of 0.20%. And it consists entirely of Treasury Inflation-Protected Securities (TIPS).

The top-level asset allocation decision between stocks and bonds determines both the ultimate return you will receive and the volatility you will experience. Bond allocations tend to get complex as investors try to make bonds act more like stocks. Invest a little in bonds, but make them quality bonds. This strategy allows you to put a larger portion of your investments in appreciating stocks.

The purpose of a gone-fishing portfolio is to set a simple allocation for each asset class so you can sleep at night and rebalance once a year. Keep some in bonds so you have stable investments with which you can rebalance if the markets fall in value.

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About David John Marotta

David John Marotta+ is the Founder and President of Marotta Wealth Management, Inc. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. Favorite number: e (2.7182818...)

Comments

  1. Dear Mr. Marotta,

    I regularly read and enjoy your column in the Daily Progress. I have two questions for you:

    1. With regard to your “Go Fishing in the Sea of Bonds” article, I noticed that you do not offer an ETF for the foreign bond allocation. Is there such an instrument?

    2. Generally, do you subscribe to the efficient-market hypothesis?

    Thank you,

    The gone fishing portfolio simplifies a portfolio’s bond holdings to just US Bond ETFs (BND or TIP). We prefer using a mutual for foreign bonds. Here are some suggestions to consider:

    • American Century International Bond (AIDIX/BEGBX)
    • PIMCO Foriegn Bond Unhedged (PFUIX/PFBDX)
    • PIMCO Emerging Markets Bond Instl (PEBIX/PEMDX)

    These are all unhedged bond funds, which means that they will fluctuate with currency movements. They go down when the dollar strengthens and up when the dollar weakens.

    And yes, we generally subscribe to the efficient-market hypothesis all else being equal. Therefore among categories you should be investing in, return follows risk. However there are some categories you should not be investing in. As some examples of what you should NOT be investing in: North Korea, annuities, and small cap growth. There are separate articles and posts which explain why some investments should not be made.

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