Fri, 11 Jan 2013
Bonds are a better option than cash and less volatile than stocks, but investors should be mindful of headwinds and possibly rethink their fixed-income allocations, says Morningstar's Christine Benz.
Jason Stipp: I'm Jason Stipp for Morningstar. Investors approaching retirement have an interesting dilemma in today's market, just as theoretical asset allocation would tell them to hold more in bonds, we see clouds on the horizon for fixed income. Here to talk about dealing with this situation is Morningstar's Christine Benz, our director of personal finance.
Thanks for joining me, Christine.
Christine Benz: Jason, great to be here.
Stipp: We're going to talk about some ways you can think about your portfolio and fixed income, but first what are the concerns in fixed income right now? Why are folks so worried about their bonds?
Benz: A couple of key things, Jason. First, is that yields are quite low, so the current yield you get on a total bond market index fund is about 1.5%--that's an SEC yield--so it's based on the previous month's yield sort of extrapolated over a 12-month period. That's very low. So, you're not getting much income from high-quality bonds right now, and that in turn detracts from the other thing you might be looking for your bonds to do, which is to give your portfolios stability. So, when yields are as low as they are now and the markets go down, bonds just don't have that same cushion there to help cushion the losses that they might if yields were lower. So bonds are not scoring well on the stability front or the income front right now.
Stipp: If the income portion isn't really paying me a whole lot, and as you said, there isn't as much cushion there, why would I even look at bonds as an option then? If it's supposed to be fixed income and not paying me income, should I just overlook bonds and put them to the side for the time being?
Benz: It might be tempting, but I would say no. I think, a recent video I did with Bill Bernstein, who is an asset-allocation guru, really spelled out the reason you'd want to make sure that you still do have bonds in your portfolio, and the idea is that it's ballast. So, you've got your equity portfolio and that's kind of your portfolio's return engine. Your long-term returns there are likely to be better than you get from the other asset classes. The bonds are there to stabilize the whole thing, and that bond position does in fact need to become larger as you get closer to needing your money.
So, you need to lock down the assets that you've managed to save and keep money on the side, and I think investors need to remember that even in a rising interest-rate environment, which could push down bond prices, bonds will still be a lot less volatile than will the stock component of their portfolio. People often look to the Large-Cap Value category to be sort of the safe component of their stock portfolio. Even there over the past decade, the standard deviation has been in the range of 15 versus just 4 for the typical intermediate-term bond fund. So, that's a stark difference and it's something that investors really need to keep in mind if they do want to try to offset some of the volatility that will tend to be inherent in their equities.
Stipp: There's a sense of correlations there, and when stocks are performing a certain way, bonds will perform a different way. But interesting there, you mentioned that some people think of the Large-Cap Value category as being safe. I think people really think of bonds as being very safe, but you also mentioned they could lose value. So, what should I think about as an investor thinking of bonds as safe in an environment like that?
Benz: I think what you want to focus on is the risk level of the bond holdings that you have. So, you need bonds, but you do want to have bonds with different characteristics. I think of high-quality bonds as being the best ballast, the best way to offset some of the volatility in your equity portfolio. But I don't think it's unreasonable to think about having some more credit-sensitive bonds that do have higher yields. The thing you need to keep in mind though is that they will be more equity-sensitive. When stocks are going down, they may tend to go down, as well. So, you need to have both types [of bonds]. The idea is to really diversify that bond sleeve of the portfolio.
Stipp: Given the tough environment that we're facing with fixed income right now, what about the portfolio perspective and the asset-allocation perspective? What adjustments should I make given that we have a tough environment for bonds right now?
Benz: It is a tough environment. I think investors who are looking at their asset-allocation positioning can think about a couple of things. First, you don't want to be Pollyannaish. You want to be mindful of what headwinds could exist for bonds and perhaps think about scaling back fixed-income exposure relative to what might have been recommended a decade ago. So, you can think about doing this on a couple of ends.
One way to think about it is if you run the numbers and find that you're light in terms of your fixed-income position, you might think about dollar-cost averaging into bonds over a period of time. So, if yields go up and that puts downward pressure on bond prices, you might have a more advantageous buying opportunity in the future. So you might actually take the money, put it into cash, and then have sort of that dollar-cost averaging plan that you'll execute over a period of months or years.
Another idea is, and a lot of investors have been taking this to heart, thinking about taking some of the money you might have otherwise earmarked for fixed income and putting it into a high-quality dividend-paying stock fund. You don't want to move all the money that you would have had in bonds into a stock fund, but maybe say 5 or 10 percentage points of that fixed-income position I think could reasonably be in high-quality stock holdings to stand in for some of that bond portfolio.
Stipp: You mentioned if you were lighter on bonds than you needed to be, but concerned, you could dollar-cost average in from a cash account. What about taking some of that fixed-income allocation and just putting it in cash and leaving it there until all of the smoke clears?
Benz: That's another strategy we've certainly heard from a lot of Morningstar.com users over the past few years. The big reason not to do that is opportunity cost, that if you have money in cash currently you're actually in the red from the get-go because you're not even keeping up with what is actually a fairly modest inflation rate right now. We have heard from our Morningstar.com users over the past few years that they've executed this strategy. The problem is bonds have actually done much, much better over the past few years than holding money in cash has done.
Stipp: If you're going to take some money out of fixed income and put it into other areas, it's not necessarily a bad decision, but you just need to know what different kinds of risk you're taking if you're putting money into cash, putting some of that fixed-income money into stocks.
The last thing, Christine, we've been hearing from readers that because yields on traditional bonds or government bonds are so low, they have been looking further afield in fixed income. These are still bonds. So conceivably, the thought is that they are still safe, but I can get more yield in high income or emerging markets. What should I keep in mind about that? Why not just get that higher yield and still stay in bonds?
Benz: That's certainly something we've been seeing in the fund flows where we have been seeing dramatic inflows into some of the higher-yielding asset classes. High-yield or junk-bond funds, emerging-markets bond funds, bank-loan funds, et cetera, have all been seeing a lot of flows. I think that investors can own some of those investments, and it's not completely irrational because they will tend to behave better in a rising-interest-rate environment. The problem is they are also a lot more equity-sensitive.
So, when you look back to a 2008-type environment, for example, a lot of those bond types had very steep losses, not maybe quite as bad what equities had, but not too far away. So, they really didn't deliver that ballast. My advice is to go ahead and dabble in some of those noncore bond investments, but keep them around the margins of the fixed-income portfolio, maybe 25% of your total fixed-income allocation at the high end, the rest should be hunkered down in those high-quality bonds and bond funds.
Stipp: Christine, those are some very timely tips for the fixed-income portion of our portfolios in this tough environment. Thanks for joining me today.
Benz: Thank you, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.