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By Christine Benz | 06-21-2012 11:30 AM

What's the Purpose of Your Fixed-Income Holdings?

Financial specialist and author Bill Bernstein says bonds should be a riskless ballast for a portfolio and offers three types of assets for investors looking for safety.

Christine Benz: Hi, I'm Christine Benz for Morningstar. I'm here at the Morningstar Investment Conference, and I'm happy to be joined today by Bill Bernstein. He's the author of several great investment books, including The Investor's Manifesto and The Four Pillars of Investing.

Bill, thank you so much for being here.

William Bernstein: It's a pleasure.

Benz: Bill, I would like to focus on fixed income today. You are an expert on asset allocation, and I think that everywhere you go right now, you hear gloomy prognostications about the outlook for fixed income. I'm wondering if you can talk about how investors should approach that allocation right now given the prospective headwinds that could face fixed-income investors in the decades ahead?

Bernstein: Well, first of all, there's a lot of concern about fixed income as you've already alluded to. People are worried that the returns are going to be low, and I think that's almost a mathematical certainty. If yields stay where they are you're going to get a very low yield; that's the best-case scenario. If yields rise from here, then you are going to achieve probably negative returns with any duration at all. Yields on Treasuries have fallen over the past 30 years from the midteens down to 0%, 1%, or 2%; they can't fall another 14% from here. And I think unfortunately people are expecting that to happen. So you have to back up and ask yourself, what is the purpose of your fixed-income assets. Well, they're for emergency needs. They're to buy stocks when they are cheap, so you can sleep at night. And they're to buy that corner lot from your impecunious neighbor who suddenly has a need of cash. It's not to achieve a return.

And so with that in mind you want your safe assets to be as safe as you can, and you should be investing in four things, which are Treasuries at the short end, and certificates of deposit and money markets, and then a clothes pin for your nose to be able to deal with those very low yields that you're going to be getting.

Benz: Bill, one conundrum that I know a lot of our readers have wrestled with is they know they are approaching retirement, and I guess I would ask you, if I were to come in to your office today and say, "I'm a couple of years away from retirement and most of my portfolio is in equities," how would you suggest that I approach the portfolio, and how would you suggest that I derisk that portfolio?

Bernstein: Well, it depends upon what your needs are. Let's take the best-case scenario; let's say you're a very wealthy person with very low needs. Let's say you've got a $5 million portfolio, and you only need $50,000 a year to live on, so you have a 1% drawdown rate. Well, stocks yield 2%, and in the worst-case scenario that something had happened, say what happened from 1929 to 1932, although the stock index went down by 90%, the dividend dollar output, the dividend throughput, only fell by 50%. So you're still safe. So you could invest if you wanted to in 100% stocks.

Benz: That's not most people feel unfortunately.

Bernstein: But it gives you a way of thinking about it.

Benz: Right.

Bernstein: Now, let's say that instead of a $5 million portfolio, you have $1 million portfolio. Now you cover your needs by a factor of 20. Really, in that situation, if you want to retire at that point, there's only one thing you should be doing, and that's to take that money and probably either buy a Treasury Inflation-Protected Securities ladder and some longevity insurance on top of it, or you could just throw it all into three or four immediate fixed annuities and pretty much cover almost all of your living expenses on that. You can't take any risk.

Now in the worst-case scenario, you don't even have that. You've only got $250,000, and in that case, I would look the person straight in the eye, and I would say, "You are not retiring in two or three years; you are working until you can acquire 10, 15, or 20 years' worth of living expenses. And that's going to mean a combination not only of working longer, but you are also going to have to decrease your consumption needs, as well."

So, it really all depends upon what your situation is.

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