Investors have been nervous about the possibility of rising interest rates for some time now, and with good reason. Mortgage rates are at all-time lows, and a ten-year Treasury is barely yielding two thirds of a percent. At this point, rates really can’t go much lower, and the reality that bond prices fall as interest rates rise has many investors worried about their exposure to interest rate risk. Nobody wants to be caught owning bond funds in a rising rate environment.
Admittedly, bond funds offer some fundamental advantages. You can more broadly diversify your portfolio by using them, and you’ll enjoy having a portfolio that’s professionally managed for total return.
However, with rates at these levels, I submit that generating capital gains in the bond market will be very difficult over the next ten years, even for the best fund managers. According to Goldman Sachs, investment grade corporate debt market spreads widened, to 153 basis points (bps) last week, thereby contributing further to an ongoing lack of liquidity. In other words, most investors will be holding their bonds to maturity for the foreseeable future. Also relevant to our current station in the market, we’re recommending that most fixed income investors stick with investment grade bonds, so a fund manager’s assessment of credit quality is less valuable-- you probably don’t want to pay the fees associated with bond funds just so that a manager can tell you that any given issuer with AA-rated credit will be around to actually pay you. If your financial advisor can’t do that for you and thereby eliminate a layer of fees, you should probably move on.
So, the fact that bonds are subject to inflation risk weighs unduly on mutual funds, for the shares don't have a maturity date. Since bond interest payments are fixed, their value can be eroded by inflation. According to the Chair of Finance Education at the Stern School of Business at NYU, Aswath Damodaran, PhD, the return during the worst 10-year period for bonds was 10 percent lower than the worst 10-year period for stocks. The chance of incurring real money-- inflation-adjusted-- losses over any 10-year period was seven times greater for bonds than it was for stocks. And while it’s significant that stocks did better than bonds 89 percent of the time over ten-year periods, the case for equities becomes even more compelling over 15-year periods, as stocks beat bonds every time and never failed to beat inflation.
On the other hand, bonds would have generated negative real money returns for every single decade from the 1930’s all the way though the 1970’s.
So, it’s fair to say that our firm addresses allocation a little differently than most financial advisors, for we eschew the traditional 60/40 mix of stocks to bonds (unless a particular investor is going to need 40% of their money in the next ten years). Instead, we subscribe to a financial planning philosophy whereby money that an investor doesn’t need for at least ten years should pretty much all be in the asset class that has historically done overwhelmingly better over that time period, and that's equities. For shorter term investment horizons, we typically invest money that an investor needs in five years in a bond that matures in five years, that money an investor needs in three years in a bond that matures in three years, and so on and so on.
We use sophisticated financial planning software to stress test our clients’ financial plans, and I can tell you that it has been extraordinarily rare over the last couple of years for a straight 60/40 asset mix to generate a better result than an asset allocation with all long-term cash needs invested in equities. That is primarily due to the long-term performance of stocks, but it is also partly because an investor can expect variable income flows from bond funds and that the total return element has basically been stripped down to the ability of the portfolio manager.
Investment grade bonds with maturities under ten years. You really don’t need to be paying your financial advisor 1% a year to safely invest in those, and you definitely don’t need to tack on another half of a percent or so for a bond mutual fund manager.
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