Like nearly all financial planners, I have a portion of my clients' portfolios in bonds, bond funds or other fixed-income investments, such as certificates of deposits. In the process, I spend quite a bit of time educating clients to think differently about these types of assets.
Part of the secret to doing bonds right is debunking four commonly accepted bond myths.
MYTH 1: THE PURPOSE OF FIXED INCOME IS TO PRODUCE INCOME.
It seems logical that fixed-income investments produce income to live on, but is it really true? I keep hearing that rates are so low today that savers are being punished and borrowers rewarded. I would argue that the truth lies in doing the math.
To see why this is a myth, we must first keep in mind the purpose of our clients' portfolios. They worked hard, lived below their means and converted human capital to investment capital. That investment capital is essentially stored energy to give them freedom to do what they want for the rest of their lives. I tell clients that their goal shouldn't be to die the richest person in the graveyard, meaning they can and should spend the principal.
Now on to why fixed income seldom produces income. Thinking back to 1980, CDs and U.S. Treasury bonds produced a handsome 12% interest rate. A $1 million portfolio seemingly produced an income stream of $120,000. Reminding my clients of those times typically brings a nostalgic smile and a longing for the supposed good old days.
There is less smiling when I remind them that taxes ate up a third of their income, and they got to keep only about $80,000, or 8%. Finally, the smile is completely wiped away when I point out that inflation averaged 13% back then. According to my calculations, this part of their portfolio actually lost about 4.6% of its spending power. Measured against the purpose of the portfolio, the returns of 1980 were actually horrible. Hard as it is for many to believe, rates are much better today.
We can, of course, increase yield by taking on more credit risk and buying lower-rated investment-grade bonds, or even playing with high-yield junk. But remember that in 2008, just as clients needed a portfolio shock absorber, the average bond fund lost 8%, according to Morningstar, and many bond funds lost over 30%. High-quality bonds, like those in the Barclays Aggregate Bond Index, meanwhile, gained over 5%.
A much better way to counsel clients is to have them view bonds as the more stable value portion of the portfolio, whose role is to keep up with inflation and taxes, and nothing more.
MYTH 2: BONDS REQUIRE PROACTIVE MANAGEMENT AS RATES CHANGE.
Interest-rate increases cause the value of bonds and bond funds to decline. A one percentage point increase in interest rates would cause a fund in the Barclays Aggregate Bond Index with a 5.6-year duration to lose about 5.6%. The Federal Reserve gives us clues when it is going to change rates as well as buy back our longer term bonds through the mechanism known as quantitative easing. Being proactive and bailing on bonds during times of rate increases should add value, right? If only it were that easy.
The Federal Reserve controls only the very-shortest-term interest rates, and a change in the overnight interest rate probably has no impact on intermediate-term bonds. There was much debate as to whether QE was having much of an effect on longer-term rates. The view was that the government's buyback program created more demand for these bonds and pushed rates lower. So when the government announced in 2013 that it would end QE in 2014, economists formed a herd that uniformly predicted interest-rate increases. The Wall Street Journal reported that 43 of the 44 economists surveyed predicted the 10-year Treasury rate would increase, with many stating that a bond bubble was imminent.
The market disagreed. Rates declined and bonds had a very good year in 2014.
This, moreover, was no aberration. In fact, it continued a long track record in which economists correctly predicted the direction of interest rates far less than half the time, which is the success rate of a coin flip. This horrible performance was uncovered more than a decade ago and documented in a study by Karolyn Mitchell and Douglas K. Pearce, professors at North Carolina State University.
The fact that we still accord these forecasts credibility and then make changes to our portfolios based on them is puzzling.
The results aren't pretty. According to Morningstar, the penalty for bad timing on bonds is huge. For the 10-year period that ended on Dec. 31, 2013, the average investor underperformed the average taxable bond fund and muni bond fund by 2.24% and 1.88%, respectively. That's a result of moving into and out of bond funds at the wrong time, probably in large part because of forecasts of interest rate changes. And don't think this behavior is limited to individual investors. Surveys of advisors in late 2013 showed that they too were intending to bail on bonds because they believed rates would increase.
MYTH 3: HIGHER RATES ARE BAD FOR BONDS.
I noted earlier that increasing rates cause bonds and bond funds to decline in value. Though that's bad in the short term, it is not necessarily bad in the long term. In the accompanying chart from Vanguard, you can see both the short-term and long-term impact that a rate increase has on bond portfolios. This bond fund happens to have a 2.3% yield and a 5.6-year duration.
Let's use an extreme example where rates surge by four percentage points in a single year and now holders of these bonds expect a 6.3% yield. That would be pretty bad in the short run, with this bond fund losing 18.1% in the first year. There is no doubt that people would panic and sell.
But if the client stays the course, then this laddered bond portfolio would be reinvesting as bonds matured, buying bonds that average a 6.3% return instead of 2.3%. This drives up the income and, over time, the return of the bond fund. You can see that by Year 5, the return is back to positive, and by Year 7, the 2.4% average annual return is greater than the 2.3% the client would have earned if rates hadn't risen at all. That is, of course, if the investor doesn't panic and sell.
There are a couple of caveats: First, the assumption is that rates then stabilize and don't keep rising. Since the best single predictor of future longer-term rates is the current rate, it's equally likely that rates could decline as continue to increase. Second, it is assumed that the numbers are nominal, not real. It's possible, and perhaps even likely, that the rate increase would be partially driven by inflation expectations.
MYTH 4: INDIVIDUAL BONDS HELD TO MATURITY ELIMINATE INTEREST-RATE RISK.
In the previous myth, I noted that the bond fund declined significantly when rates shot up. It seems logical that buying individual bonds and holding them until maturity eliminates this risk. Unfortunately, that is merely an illusion.
Let's say an investor buys a one-year corporate bond at a $1,000 face value that pays a 4% interest rate at the end of the year. She expects to get back $1,040 in a year. Her bond is worth $1,000 today because the market pegs the 4% rate as fair for this type of bond. The math behind it goes like this: $1,040/1.04 (one plus the interest rate) = $1,000.
In this hypothetical example, immediately after she buys the bond, news comes out that inflation is expected to increase. Suddenly, investors want a 5% yield on this type of bond. Looking up the value of her bond, the holder finds it is now worth only $990.48 ($1,040/1.05), having declined by $9.52. Still, this investor may take comfort in not having lost a dime as she is still going to get the $1,040 back, which is exactly what she bargained for.
Unfortunately, she is going to receive only $40 interest when the market now demands $50 interest for this type of bond. This translates to receiving $10 less in one year, based on the current 5% return expectation. The investor is immediately out $10.00/1.05, which is exactly equal to be the $9.52 decline in value of her bond. This is not merely a coincidence. The math always works out the same irrespective of the interest rate or the maturity of the bond. That is to say, the change in the current value of the bond will be equal to the present value of the cash to be received from the interest payments and the return of principal.
Simply put, if interest rates increase, there is a decline in the value of the fixed-interest payments and the return of principal. Holding the bond until maturity does nothing to protect the investor from increasing interest rates. The investor receives less money than the current market would dictate.
The real benefit of individual bonds versus funds could be psychological if it helps avoid panic and selling after market declines.
THE ROLE OF BONDS
Summing it up, these four bond myths lead to bad client behavior. Helping clients understand these misconceptions and rethinking the role of bonds is the key to better behavior, which leads to higher overall portfolio returns. As I tell my clients, the role of equities is to grow the portfolio, but the role of bonds is merely to keep pace with inflation and taxes and to provide courage to rebalance and buy more stocks when they tank. To meet these goals, in terms of both the underlying bonds and the strategy in managing the bonds, keep in mind that boring is better.
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for various AARP publications and has taught investing at three universities.