The issue of owning bonds

The reader asks:

It has historically maintained an allotment of 35% US index, 33% international index, 30% bond funds, and 2% speculative in stocks. Bonds have been crushed. Should I continue to hold this assignment knowing that this portion will definitely go down in value? I’m thinking of moving a portion of my bond allocation to some strong company that has been battered but pays 2-3% dividends. I used to think my bond allocation is too high given the investments in real estate. 49 years old, high income earner, high savings rate, $1 million in retirement accounts, $2 million in property (home and rent). ideas?

It is true that the bonds have faded. But the bloodbath was not evenly distributed:

Long-term bonds have been hit. The overall bond market and medium-term bonds are in a meltdown (in terms of bonds). Short-term bonds declined but not as much.

Bonds could continue to falter if interest rates continue to rise on their current path.

Predicting the direction and magnitude of interest rate movements is one of the most difficult things to do in the financial markets.

I don’t know of anyone who can do this on a consistent basis.

Just look at how bad professional forecasters are at predicting interest rates:

It’s not easy.

And even if interest rates go up from here, for the first time in a long time, there really is a decent cushion for losses in terms of yield.

The 10-year Treasury last week reached levels not seen since early 2011:

bond crushing It means that bond yields in the future are higher now.

You see that bond returns are guided by mathematics while stock returns are determined primarily by emotions (how much people are willing to pay for them).

Bond yields can be calculated using the starting yield and discounting any type of credit or default risk.

So if we’re talking about US government bonds, the initial yield is a good place to gauge the expected returns.

However, this is only true for long-term returns. Anything can happen in the short term.

For example, here the 5-year Treasury yields start compared to the 12-month forward returns:

Two things stand out from this chart: (1) one-year yields everywhere and (2) last year saw the worst returns for any 12-month period since 1962 for 5-year Treasuries.1

The beginning returns and one-year returns have a correlation of 0.6, which is a positive relationship but certainly not ideal in terms of joint movements in the same direction.

Now let’s look at 3 years into the future:

This is a little closer. The correlation here is 0.85 which is stronger but there are still some differences.

Now let’s look at the 5-year performance from the beginning of yields on 5-year Treasuries:

Now see how close the lines are.

Five year returns and starting returns have a correlation of 0.92 which is still not 1 for 1 but makes for a very strong correlation. The initial yield is a strong indicator of the five-year future returns.

The initial yield doesn’t do a great job of predicting returns in 6-12 months, helps somewhat over 3 years but is very useful over 5-10 years (depending on the maturity of the bond).

The case against owning bonds is now clear:

  • Inflation is high and could go up.
  • The Fed is tightening.
  • Interest rates can go up.

It is certainly possible that owning a bond can lead to a bumpy ride for a while. Again, I can’t predict the course of interest rates.

But let me play the devil’s advocate to see the other side of this argument. Here’s the status of owning bonds now:

  • Yields are much higher than during the onset of the pandemic.
  • The Federal Reserve raises interest rates to reduce inflation that could lead to a recession.
  • If we enter a recession, yields will likely fall as the Fed will eventually have to cut interest rates.

The cause of a bloodbath in a bond is the same thing that can end a bloodbath.

Confused yet?

And even if we don’t go into a recession but inflation drops and rates stabilize, bonds should do much better than they have over the past 18 months or so.

All I know is that the expected long-term returns of bonds are now much higher than they were a few years ago.

Having said that, this does not necessarily mean that you have to invest in bonds.

This person asked if they really needed a bond allocation because they had such a large share of real estate.

There are investors who view debt repayment as a form of fixed income investing. Paying off a mortgage gives you a fixed return much like a bond. Also, rental properties eliminate income so I see the similarities.

However, there are some differences between owning real estate and owning bonds.

The bond is liquid. You cannot spend or use your real estate investments to rebalance your liquid portfolio. It is also much more difficult to diversify into housing.

So this question really boils down to why you own the links in the first place.

Do you want to get out of bonds because you have experienced some losses or because it does not fit with your personality or risk profile as an investor?

Is it some form of volatility reduction? dry powder? Income generating?

There are a lot of investors who do not use bonds but you have to understand the risk profile of a portfolio invested in stocks and real estate only.

I understand why so many investors are sick of allocating bonds right now.

The bonds haven’t helped offset losses in the stock market this year. High inflation was a double whammy against fixed income assets.

But bonds can still play a role in a well-diversified portfolio. They can still protect against deflation and inflation in the economy.

And they now have much higher returns than in many years.

It all depends on how you want to build a portfolio and the types of diversification required to help you achieve your goals.

We talked about this question at Portfolio Rescue today:

Dan Larrosa also joined me to discuss crappy 401k plans, 401k loan plans, and more.

Here is the podcast version of today’s programme:

1I’m using month-end data here until the end of May.

Leave a Comment