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Should You Be Scared to Own Bonds?

In the last week, I’ve received a few emails from readers who were concerned about a recent MSN Money article. The following snippet sums up the main message of the article:

“In just the past four years, investments into bond mutual funds have doubled to $4 trillion. But this perceived bastion of safety is more like a ticking time bomb waiting to explode. And when it does, it will devastate any portfolio with a heavy allocation to Treasury bonds.”

Scary language. But based on the portfolios I see most often, I don’t think most investors need to be scared about anything that could be referred to as a bond explosion.

Bond Bubble Fears

It’s true that interest rates are currently very low, and it’s true that bond prices go down when interest rates go up. But there’s no telling when interest rates are likely to rise. They could fall first (though not very far) or stay right where they are for an extended period of time.

In addition, with short-term or intermediate-term bonds, the losses would be very unlikely to approach anything like the losses that can occur in the stock market.

For example, Vanguard’s Intermediate-Term Treasury Fund has an average duration of 5.2 years. Even if rates rose by 3% overnight, that’s only a ~16% decline in price — not even close to what can happen to stocks in just a run-of-the-mill bear market. And most of the the time, rates don’t increase overnight. Instead, they increase over a period of time, during which an investor in a bond fund will be earning interest that will help to offset any declines.

By way of analogy, if the popping of a stock bubble is like the popping of a birthday party balloon, the popping of a bond bubble is like the popping of a bubble on a sheet of bubble wrap.

That said, there’s no reason for bond investors to be particularly optimistic.

Realistic (Low) Expectations

In a webcast last week, Ken Volpert (the head of Vanguard’s Taxable Bond Group) suggested not to expect returns of more than 1.7% or so from Vanguard’s Total Bond Market Index fund for the near term future. Based on reader correspondence, I know this surprised some people given how much lower this figure is than historical averages.

But this projection should be no surprise because, at any given time, the current yield on a bond fund is the best estimate we have for what return the fund will earn over the fund’s duration. And the yield on Vanguard’s Total Bond fund is currently sitting at just 1.64%.

In other words, for the near future, we should probably expect bond returns to be significantly below historical averages. And we should definitely expect bond returns to be below recent past returns (a large portion of those recent returns having been due to price increases as rates dropped).

The Takeaway

In short, a period of very low (or possibly even negative) inflation-adjusted returns for most bonds is very likely — almost a mathematical certainty. But, unless your bond portfolio has an unusually long average duration, a calamitous drop is still far more likely to come from the stock side of your portfolio than from the bond side of your portfolio.

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Comments

  1. Great summary of the current bond situation!

    Wouldn’t it be prudent to move into shorter term bonds? For instance, my analysis shows that if I move from the Vanguard Total Bond Market Fund to the Vanguard Short-Term Investment Grade Fund and interest rates go up by 1% in the next 6.4 YEARS, then I will come out ahead. IMHO, An increase of 1% seems more likely than not in the next 6.4 years.

  2. rjack,

    Not to say that such a shift is necessarily a bad idea, but making that change not only reduces duration, it also increases credit risk.

    For example, if we kept credit risk (closer to) constant and compared Vanguard Short-Term Investment Grade to Vanguard Intermediate-Term Investment Grade, a 1% increase in market interest rates would have to happen in roughly the next 3 years instead.

    Ditto for a comparison of Vanguard Total Bond Index Fund to Vanguard Short-Term Bond Index Fund.

  3. Nice job bursting the bond bubble hysteria.

    The reality is the Federal Reserve has bought up and continues to buy up such a large percentage of outstanding Treasuries that the lack of supply coupled with continued excess capacity in the economy should keep rates low for the time being.

    There will be plenty of time to reduce duration when conditions change.

  4. So would you recommend first buying IBonds to the maximum extent possible and then investing in BND to make up your total allocation of bonds in the portfolio ? Or the other way

  5. John,

    There are a lot of factors at work here. For example, if the entire portfolio is in retirement accounts, I Bonds are a no-go anyway because they can only be bought in taxable accounts. And conversely, if much of the portfolio is in taxable accounts, depending on the investor’s tax rate, tax-exempt municipal bonds should be considered as a possibility.

    And regardless of the investor’s circumstances, there are going to be numerous possible solutions — any of which could result in a suitable overall risk level for the portfolio.

    For example, I think a Total Bond fund is perfectly fine as a core bond holding.

    Alternatively, I think it’s perfectly reasonable to do what Bill Bernstein suggested in an interview yesterday: stick with short-term Treasury debt for the bond portion of the portfolio. While I don’t think a bond collapse is imminent, using short-term bonds does in fact reduce risk, thereby allowing slightly greater risk to be taken in the stock portion of the portfolio.

  6. Thanks for the timely advice Mike. Your post and the complementary Bernstein interview were good reinforcements for me since I have just rebalanced my accounts for the first time in a couple years, which meant selling stocks and buying bonds.

    On top of recent market gains, this was also done to lower my asset allocation from 70/30 to 60/40 because of my age, and because my wife has retired and I can no longer use dollar cost averaging to assist in keeping my allocation according to our Investment Policy Statement [her accounts are allocated 35 / 65 despite her being younger than me - a matter for our on-going family discussion about risk, plus asset location].

    The last time I rebalanced was in March 2009 and I was selling bonds and buying stocks, which was [maybe, a little] easier at the then current valuations. For the past couple years I have resigned myself to future low returns/interest rates and the thought that lower risk [and the return OF my money] is more important at this time than the return ON my money.

    I guess if you are rebalancing correctly it will never feel completely comfortable.

  7. Thank you for this useful and timely article – I have been agonizing about the bond portion of my 401K and unable to come to a satisfactory decision. Reading Merriman’s 2013 outlook yesterday, they suggest using both short term treasuries and intermediate term treasuries. Given how corporate bonds dropped during the most recent crash, I think I prefer to stick with treasuries. Won’t get any return, but it will help balance the risk in the equity portion of my portfolio.

  8. Tara, that is precisely what William Bernstein has always suggested: Use Treasuries for lessening [balancing] the risk of your portfolio’s risky assets [equities], because the expected “risk premium” on equities is higher than on bonds in the long term, and because as you mentioned, when stocks plunge corporate bonds can be expected to NOT provide the safety that you desired.

  9. Sorry, I meant that treasuries lessen the portfolio’s risk not that they lesson the risk of equities! DUH!

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