What to Do When Bonds Are No Longer the Answer

What to Do When Bonds Are No Longer the AnswerBonds have been your best buddy. They have been right there with you during the 1987 crash, the Enron fiasco, the 1990 recession, the Asian Currency Crisis, the Dot-Com Bubble, and the Financial Crisis. From Reagan to Bush to Clinton to W. Bush to Obama and now to Trump, investing in fixed income securities through funds, ETFs or individual bonds has been the way you rescued your clients from that fickle, crazy stock market. And now, your buddy is about to say goodbye. You should say goodbye to him, but will you? If you know what’s good for your practice, you will.

You see, the math for bonds no longer works. After 35 years of generally declining interest rates around the world, Treasuries, Corporates, Municipals, Preferred Stock and Non-US Bonds have reached the point where there are three possible outcomes and two of them are bad (kind of like passing instead of running in football). Bonds can produce low positive returns as they have the past few years, they can produce negative returns, or they can produce high enough positive returns to fund your retired clients’ lifestyles. The latter outcome is the only one that helps you be a hero to your clients. But if you are counting on that for the remainder of this decade, you just might end up being cast as the villain.

Bonds are no longer the answer as a core generator of low-volatility, low-stock market correlation returns that do the heavy lifting to fund retirement income strategies. But if you open your mind a bit, and think through the client’s objectives in a business-like approach, there is a clear path forward. And it does not include owning bonds, bond funds or bond ETFs.

THE FORMULA

Why do you own bonds in the first place?  I assume it is because you want the following:

  1. Sufficient after-tax income to fund expenses (3-4% or more, annualized)
  2. Income that is largely predictable (i.e. it won’t fluctuate by 3% per year)
  3. Strong liquidity
  4. Modest return potential above the income received (to fight inflation). Alternatively, if the income level in dollars can eventually rise over time, that accomplishes a similar goal.
  5. Protection from large, sustained declines in the stock market (2000-2002, 2007-2009)
  6. Protection from large increases in interest rates and widening “yield spreads” between U.S. Treasuries and the types of bonds you hold

BONDS ARE NO LONGER THE ANSWER

BONDS DON’T CUT IT ANYMORE

BONDS DON’T CUT IT ANYMORE

These are all things you relied on bond market investments to do for decades.  And now you should be very skeptical that they can continue to deliver.  Here is why, point by point:

  1. Using ETFs to represent some major bond market sectors, we see that the yields on Treasuries, Corporate and High Yield Bonds have all fallen by more than 1/3 since the start of this decade. For instance, the corporate index (LQD) used to yield 5.5%. Now its below 3.5%.  That matters to retirees and near-retirees who rely on a relatively fixed income, and it has forced many of these folks to reach for yield by investing in all sorts of lower credit quality, lower liquidity bond vehicles.  So yes, you can meet the client’s yield requirement, but only by taking on a much larger level of risk.
  2. Now that the bond market has woken up to the potential for higher rates in the coming years, that income level will not be nearly as predictable. The market is entering an intense period of “price discovery” which could cause yields to gyrate, and ultimately trend higher. So, predictability of income is greatly diminished.
  3. You can get good liquidity in some bond ETFs and mutual funds, but how liquid are the underlying holdings in those funds? Big money investors are increasingly bypassing the purchase of individual bonds, since ETF companies allow them to pile in and out of the bond segment they like in a single trade.  Good for them, but do you realize what that does to the nature of the bond market? If you are not sure, think about what high frequency traders have done to disturb the stock market.
  4. Rates would have to continue lower from here to boost bond returns above that of recent interest rate levels. That may happen over short periods of time, but as I see it, the scale has now tipped in the direction of higher rates, not lower.
  5. When stocks have fallen sharply in recent years, bonds (particularly Treasuries) were there to ease the fall. But that relationship is changing quickly, as we witnessed in the few weeks following the U.S. election
  6. By now, you probably know what I am going to say about this. Bonds do not protect you from rising rates and widening spreads, they are part and parcel of that situation.

THE BONDLESS RETIREMENT INCOME PORTFOLIO: IT’S FOR REAL

So what is a bond investor to do?  This is something I have contemplated for years.  Fortunately, my business partner Rob Isbitts did too, and he developed an approach that we think threads the needle between the often-competing needs of portfolio income, total return, hedging against major loss, liquidity and a way to combat rising rates.  We call it Hedged Dividend Investing.  Here is how it works, and how it replaces the buddy called Bonds that you have relied on since you were a young pup in the industry:

  • A “Long” Side: a portfolio of individual stocks with a dividend-income focus. Dividend income is preferable to interest income, as for most investors, dividends are taxed at more favorable (lower) rates than bond interest for most high net worth investors.
  • A “Short” Side: an investment that is expected to move in the opposite direction of a broad segment of the stock market. This is designed to combat a potential large drop in the stock market, the kind that can set a retirement portfolio back years. (We also refer to this as the “hedge” in the portfolio.)
  • A Process: to manage the mix of long and short.  Constantly evaluate the reward/risk tradeoff available to investors and position the mix according to your best thinking.

The investment world has changed…we had better change with it.  Constructing retirement portfolios today requires a very different mindset than what might have worked in the past. I invite you to challenge yourself to think beyond traditional approaches to portfolio construction and asset allocation. Your clients will thank you.

Download Sungarden’s Hedged Investing Handbook HERE.

This material was compiled by Sungarden® Investment Research. Sungarden Investment Research provides advisory services through Dynamic Wealth Advisors. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Past performance is not a guarantee or a reliable indicator of future results. Investing in the markets is subject to certain risks including market, interest rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. SungardenInvestment.com does not provide personal investment advice.