Bonds are boring. And maybe they should stay that way. Unfortunately, some investors have been tempted to veer off-track in their bond investing by current circumstances in the fixed income markets. In accordance with the evidence available on sound portfolio construction, investors are well-served by avoiding knee-jerk reactions to the latest fixed income trends, and instead considering their fixed income allocations within the greater context of (1) their overall, globally diversified, properly allocated portfolios and (2) their personal financial goals.
First, we need a bit of stage-setting. Investment professionals and financial writers tend to use the terms “bonds” and “fixed income” interchangeably. It’s important to note that there are technical differences. To name a few examples:
- Fixed income Treasury securities with maturities of up to one year are called bills. If their maturities are between one and 10 years, they are called notes. If they’re over 10 years, only then are they called bonds.
- Corporate fixed income offerings can be called bonds or debentures, depending on their terms.
- FDIC-insured Certificates of Deposit (CDs) are not bonds.
We include all of the above and more within the broad category of fixed income investments designed, principally, to be less risky than other types of investments (such as stocks) within a total portfolio. For our purposes, assume we’re talking about instruments that are:
- Issued by credit-worthy borrowers (i.e., not junk)
- Making regular, periodic interest payments
- Having a fixed maturity date for the return of capital (i.e., the amount you invested to begin with)
There have been two strong recessions in the past dozen years, causing unprecedented levels of daily volatility in the stock market. The Federal Reserve has kept interest rates at the lowest levels we’ve seen in our generation. By issuing a downgrade of U.S. Treasuries this past summer, the Standard and Poor’s ratings agency has even called into question our country’s credit worthiness. All of this has conspired to cause many fixed income investors, in a variety of ways, to attempt to squeeze more out of their fixed income allocations than is probably wise.
Go Anywhere, Going Nowhere
Among the responses to the market’s jittery conditions has been a proliferation of so-called “unconstrained” bond funds. (In November, Morningstar even created a new category for these funds, called nontraditional bond funds or “NT funds,” which now includes 37 funds.) And, they have attracted money in droves. Assets have ballooned from $3 billion in 2009 to $60 billion in 2011.
The mandates of these funds give managers virtual carte blanche in seeking out bond market returns. They can obtain exposure to any sector, credit-risk, country and currency, and virtually any duration, including going short. A few of the funds sport “absolute return” mandates, like hedge funds, attempting to achieve a fixed return above inflation (say, 1 percent or 3 percent) with little or no volatility. The managers’ pitch is that they can avoid the eventual sting of rising yields, while at the same time generate positive returns; all the while avoiding risk.
This represents a great leap of faith in the ability of active managers and calls to mind the adage, “If it sounds too good to be true….” Moreover, firms charge handsomely for the privilege of investing in their funds: we’ve seen prices ranging from 0.67% to 2.16% annually. Remember, these are bond funds. The expense ratio for the Vanguard Total Bond Market Index Fund (VBMFX) is 0.22%. (Here and following, we don’t mention specific funds to either recommend or pan them, but as examples for the purpose of discussion. The VBMFX is designed to track the BarCap US aggregate bond index, long considered the leading benchmark for the total bond market.)
Certain of these strategies may ultimately produce higher returns than a plain vanilla bond strategy, but not without important risks worth considering. For the three years ending December 31, 2011:
- The average annual return of the VBMFX was 6.64%. The fund carried a standard deviation of 2.92 and a Sharpe ratio (return per unit of risk) of 2.18.
- The average NT bond fund had an average annual return of 7.74%, but had a standard deviation of 4.67 and a Sharpe ratio of 1.52.
- The largest NT fund, PIMCO Unconstrained (PFIUX) returned 6.34% (0.30% lower than VBMFX), and still had inferior risk metrics, with a standard deviation of 3.01 and a Sharpe ratio of 2.02.
No NT fund beat the VBMFX in 2011, which gained 7.77% for the year. The average loss for NT funds in 2011 was -1%.
Another good case in point is the Templeton Global Bond (TPINX) which has been gathering assets at a torrid pace. It grew from $100 million in 2001 to $58 billion in 2011, attracting $14 billion in the first three quarters of 2011 alone. (Technically, TPINX is in the World Bond category, but it has a style similar to NTs.)
Acclaimed manager Michael Hasenstab has recently steered the fund away from developed markets like Japanese and Euro denominated bonds and into emerging markets. As a result, the fund has taken on stock-like risk, achieving a correlation, or “similarity” to the S&P 500 of 0.8 over the last three years. Perfect correlation would be 1.0, so we would consider 0.8 to be pretty high for two such typically distinct asset classes. The fund lost 7.76% in the third quarter of 2011 when the S&P 500 fell nearly 14%. That same quarter, the BarCap Aggregate was up 3.82%. Overall, while TPINX has achieved a mean return of 9.35% over the last three years, it has come with a steep standard deviation of 10.34 and a Sharpe ratio of only 0.91.
Before focusing on any of these short-term returns too closely, note that during other short-term periods, the returns could just as easily have been dramatically different. The comparisons don’t necessarily illustrate particular outcomes one way or the other, but rather that the risk and uncertainty contained within these NT fixed income vehicles is telling, particularly in relation to whether they have an appropriate role to play in a soundly constructed portfolio.
Going Global, Prudently
As with unconstrained bond strategies, international bonds have also become all the rage. And they come in many flavors.
Dim sum are bite-sized Chinese delicacies and one of my favorite dining experiences. But dim sum bond strategies, which are Chinese-Yuan denominated, have recently produced indigestion. China’s burgeoning trade surplus over the last few decades, combined with its government policy of limiting the Yuan’s potential depreciation against the U.S. dollar, had allowed U.S. investors to make money in spite of the paltry interest rates offered by Chinese issuers. But even that speculative trade ran in to a brick wall in the second half of 2011, as the Chinese trade surplus fell from 5.1% of GDP to 3%, the Yuan stopped rising in value, and investors lost 6.5% during that time frame. The average local-currency denominated emerging markets fund lost 3.2% in 2011.
Still, despite the shortcomings of the NT bond category and the more speculative forms of international bond investing, there may be a good case for adding international bonds to a traditional portfolio—if approached in a measured way.
With increasing globalization over the last decade, foreign bonds have become the world’s largest asset class, now comprising 35% of the pie. (U.S. equities are 19%; international equities are 23% and U.S. bonds are 23%.) It is impossible to predict whether, over time, foreign bonds will sport higher interest rates and hence higher returns. However different countries always have different degrees of fiscal health, and yield curve shapes around the world have always varied from one another. Consequently, returns have diverged significantly, presenting good opportunities to:
- Increase diversification across countries, sectors and issuers, helping to reduce the overall risk of the portfolio;
- Take advantage of the lower international corporate default rates than have historically existed in the U.S.; and
- Manage currency risk. Unhedged bonds show a level of volatility more similar to stocks than to bonds, often defeating the purpose of adding bonds to a portfolio. Hedged global bond portfolios, on the other hand, have demonstrated 25% less volatility than U.S.-only portfolios, with similar returns, thus providing better risk-adjusted returns.
Both Vanguard and Dimensional Fund Advisors have announced the introduction of low-cost, currency-hedged international bond funds for both developed and emerging markets. These are expected to be available this year, and we will be looking for ways to add this asset class to our portfolios.
Why Fixed Income, Anyway?
Bonds and fixed income have traditionally served two major roles within the portfolio: to dampen portfolio-wide risk and/or to provide a reliable stream of income, for purposes such as withdrawal during retirement. Because of historically low interest rates, many articles in the financial press have bemoaned the fate of the “income” investor, perhaps contributing to the yield-chasing we have seen.
Some pundits, even respected ones, have encouraged investors to consider moving portions of their fixed income allocation out of bonds and into dividend-paying stocks. They argue that the yield on “high-quality” stocks (3–4%) is greater than the yield on 10-year Treasuries (around 2%). While this approach may have superficial appeal, for the investor who is using bonds to reduce risk in their diversified portfolio (most of us), this strategy overlooks the impact such a move is expected to have on a long-term, portfolio-wide investment strategy.
Dividends are indeed an important component of total return and a useful portfolio building-block. But dividend stocks are still stocks. And the role of stocks within the portfolio is to seek expected return commensurate with expected risk. If there’s one premise that has been demonstrated time and again by any number of academic studies the world over, it’s that market risk and expected long-term return are intimately interrelated. Thus, it seems counterintuitive to seek to minimize risk and stretch for return with one and the same instrument.
To return to thinking about how to manage the fixed income portion of a portfolio, the main concern is not whether an individual act may seem promising or disappointing in isolation. Our crystal ball is simply too cloudy to know what the future holds at that level of granular detail.
What we can do is heed the body of evidence that offers us guidance on how individual market components are expected to interact and impact each other within a larger portfolio. It’s like building a solid bridge. By focusing on both the quality of the materials as well as their contributions to the total structure, investors can hope to see their way safely to the other side.