By Massi De Santis
Most investors are so focused on their stock portfolios that bonds are often just an afterthought. For many of them, a bond portfolio means stable value or money market funds. However, the role of bonds is just as important as the role of stocks for a successful investment experience, and even more important for some goals. The right bonds help you avoid unnecessary risks and make the most out of your portfolio, particularly in a low interest rate environment. A good bond portfolio acts like a reliable brake system on a racecar: good brakes won’t make the car go faster, but it will make it go faster around the track. If you are not the race type, you know that good brakes help you arrive safely at your destination. That’s the role of bonds, and more.
A salient feature of bonds is that there are many different types out there: different payment schedules, risk levels, taxability, inflation adjustments, and country of issuance. This broad availability means that we can pick and choose different types of bonds to meet different investor goals and needs. The bonds you hold in a retirement savings account will be different from the bonds you hold for short-term goals, like a future large purchase, and different yet if your goal is to generate income, or to prepare for a short-term expense.
Investors don’t have to buy and sell bonds directly, they can choose to invest any desired amounts in the many bond mutual funds and ETFs designed with these characteristics in mind. So when we say ‘bonds’ in this article, we simply mean bond funds.
Low interest rates
Many investors wonder what they should do differently in a low interest rate environment. The approach we discuss here works well all the time, and it is particularly beneficial in low interest rate environments. Low interest rates tell us what we should already know – that bonds cannot be an important determinant of growth in a portfolio. But that’s never the role of bonds in the first place. The low rates further highlight the importance of being as efficient as possible when we design our portfolios. Choosing the right bond is even more important in a low rate environment, just like having a good mpg on your car is more important when gas prices are higher.
Determinants of Bond Risk and Returns
Selecting bond portfolios should be viewed as a refinement of the goals-based investing framework we discussed in prior posts. The first step is to use your goals to define the investment horizon and the asset allocation. The bond portfolio is then built by using funds that have characteristics that best match your goals.
There are four elements of bond returns that you can use as levers to build your portfolio. The first is duration, which is a measure related to the average maturity of the bonds in a portfolio. Bonds of longer maturities have yielded higher returns on average. However, the longer the duration, the greater is the potential for the bond portfolio to change in value over time, due to changes in interest rates. That may or may not be a risk that matters, depending on your goals, which makes duration a useful lever for bond selection. You can easily find the duration of a bond fund by simply looking at the factsheet, typically reported on the website of the fund.
Determinants of Bond Returns
The second component is default risk, which represents the likelihood that a bond will not make the promised payments. U.S. government bonds are thought as very safe and have little or no default risk. Certain corporate bonds are thought to be just as safe as government bonds, while others may be riskier. Rating agencies rate bonds and bond funds publish their average ratings on their factsheets, so this too is a readily available measure for investors. Investment-grade bonds have an S&P rating between AAA and BBB- included.
The third element is inflation. Inflation lowers the real value of a promised dollar payment in the future. The longer the maturity, the greater the effect of inflation. To preserve the purchasing power of the future payments in today’s dollars, some bonds and bond funds make payments that are adjusted with actual inflation. These bonds are called inflation-protected, inflation-linked securities, or real return securities.
Finally, the interest rates that you can earn in different countries will be different over time. You can use global bond funds to invest in bonds issued in different countries achieving greater diversification in your bond portfolio.
Let’s see how we can apply the four levers in different portfolios, depending on your goals.
Bonds in a Growth Focused Portfolio
By definition, growth portfolios are riskier portfolios designed to maximize the growth potential of the overall investment. They are created for long-term goals, typically with horizons of ten years or more. In these portfolios, the general role of the bonds is to help to smooth out extreme returns over time.
● Goal: long term growth (future retirement, education planning, legacy planning)
● Role of Bonds: volatility control
● Duration: flexible
● Default risk: flexible within investment grade
● Inflation: protection not important
● Global: provides diversification
For growth portfolios, the bond component should be diversified across the bond universe, including government, government agency, corporate, and global bonds. A well-diversified bond investment can reduce portfolio variability while contributing to total returns. The growth focus of the overall portfolio gives you some flexibility in terms of duration, but a good range will generally be in the intermediate range (about 5-7 years). Broad, investment-grade corporate bonds should be included. On average, intermediate bonds have yielded higher returns than short-term bonds, and corporate bonds have yielded higher returns than government bonds. Longer-term bonds are not needed because of the emphasis on equities, and can be avoided given their greater volatility. In terms of broad indices, think of the Bloomberg Barclays Global Aggregate Bond Index or the FTSE World Broad Investment-Grade Bond Index.
Bonds in a Conservative Wealth Portfolio
Conservative portfolios are typically constructed for high-priority, short- to mid-term goals (1-7 years), such as a safety net, large purchases, or college expenses starting in a few years. In these cases, the portfolio will be completely liquidated at the end of the horizon. The goal of the bonds here is to reduce risk and preserve the value of the accumulated portfolio.
● Goals: short-term, with liquidation on the horizon. Growth not a focus.
● Role of bonds: preservation of the investment and loss avoidance
● Duration: short to intermediate
● Default risk: low
This can be achieved with short to intermediate bond durations that are similar to the horizon of the goal. Only high-rated bonds should be included to reduce volatility related to default risk. In terms of broad indices, think of a combination of the ICE BofA US 3Mo T-Bill Index (ultra-short), and the ICE BofA 1-5Y US Corp & Govt Index (intermediate). A global short-term index, like the FTSE WGBI 1-2 Yr Index can also be included if global exposure is desired. The actual combination can be chosen to obtain an average duration across bonds that approximates the horizon of the goal. Inflation protection is generally not needed given the short-term nature of the goal.
The purpose of income portfolios is to sustain steady payments for a long period of time. Even if the withdrawals are starting soon or have already started, the goal is typically long-term, over 10 years or more. Long-term income generation is more important than short-term volatility.
● Goal: long term income generation;
● Allocation: high in bonds; growth not important
● Role of Bonds: generate steady income
● Inflation: protection typically important
● Maturity: long; matching the horizon.
● Default risk: moderate exposure.
Because of the duration of the goal, the bond portfolio should seek longer maturities among government bonds and inflation-protected bonds to help maintain the purchasing power of the portfolio. A good approximation to the duration of the goal is the average maturity. For horizons 20 to 30 years, average maturities are 10 to 15 years, so durations up to 10-15 years can be appropriate, as short-term movements in the portfolio are of less concern in an income portfolio. A moderate level of investment grade, corporate bonds can also be added to enhance the ability to generate income. Look for index funds with inflation-protected bonds and combine them with funds that target government and corporate bond indices. Examples include the FTSE US Inflation-Linked Securities and the Bloomberg Barclays US Long Govt and Credit Index.
Diversification and Low Costs Matter for Bonds, Too
There are some general principles that hold for bonds too, particularly diversification and low costs. Don’t concentrate your investments in individual bonds that pay the highest coupon or have the highest promised yield. Taking unnecessary risks with individual bonds is not a good risk management practice. Plus, bond trading in small sizes is costly. Use bond funds and ETFs instead. It is possible to invest in diversified mutual funds and ETFs at a very low cost, typically around 0.25% expense ratio or lower. Don’t invest in high fees, actively managed funds. The value of a good bond portfolio is not in maximizing returns, but properly managing the risks that matter for your goals in a cost-effective way.
Putting it Together
We offered three goal scenarios for the bond portfolios, so you may wonder what to do in other cases. The answer is that most other cases can be thought of as a combination of some of these three cases. For example, when you are saving for a retirement goal, you start with a growth portfolio and gradually transition to an income-based portfolio, or a combination of an income-based portfolio and a short-term wealth portfolio. You can follow glide paths similar to what we discussed in A Common Sense, Goals-Based, Approach to Your Investment Plan.
Similarly, your wealth portfolio may transition from intermediate to short to immediate. That means that you can start with a bond portfolio with an intermediate duration that includes corporate and global bonds, and you transition to a bond portfolio with shorter duration and a heavier emphasis on government bonds over time, maybe all the way to a money market fund as you approach liquidation.
In general, by using the four levers of duration, default risk, inflation, and global exposure you can tailor your bond investments to all of your specific goals. Repeat the process for each goal in your portfolio to derive your bond portfolio.
About the author: Massi De Santis
Massi De Santis is an Austin, TX fee-only financial planner and founder of DESMO Wealth Advisors, LLC. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.