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By Christine Benz | 02-21-2013 09:00 AM

Ibbotson: Danger in Reaching for Yield

Fixed-income investments are still necessary, but with tight credit spreads right now, obtaining extra yield carries heavy risks, says Zebra Capital chairman Roger Ibbotson.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. I'm here at the Morningstar Ibbotson Conference, and I had the opportunity to sit down with [Zebra Capital chairman] Roger Ibbotson, who shared his outlook for the bond market today. Roger, thank you so much for being here.

Roger Ibbotson: I am glad to be here.

Benz: You are an asset-allocation guru, so I always like to pick your brain about what your thoughts are on various asset classes. One of the most vexing areas for all investors right now is fixed income. People are looking at very low yields and the prospect of potentially rising interest rates and really wondering about how to handle this portion of their portfolios. Do they need bonds? I'd like to get your thoughts on that question?

Ibbotson: Yes. The yields really are very low right now. In fact they are under 2% for the, say, intermediate Treasuries, 10-year Treasuries, and you will not get the kind of returns you got in the past. So people sometimes have looked at the last 30 years, and they said, "Well, for the last 30 years, bonds did as well as equities. They both did great, but bonds did as well and had much less risk. Why don't we do that that again?"

That would be a really terrible thing to think you are going to get that again because the reason why returns on bonds were so high is, they started so high.

A return on a bond is a yield, plus the capital gain, which is the change in yield. So when the yield drops, the price goes up and you get a capital gain. So between those two pieces, this last 30 years has been a remarkable period for bonds. They've done remarkably well, but the reason was they started at such high yields. Now, that the yields are low, you're not going to get it again. So there is no possibility that you get those same high returns on bonds going forward.

Benz: So even for people, though, who know that they won't get a high return, but still want some ballast in their portfolio for their equities, do bonds still make sense? What would you counsel them, because there are lot of people who are in retirement, getting close to retirement. They know that they need to have a safe portion of their portfolio. They need to have some money battened down to meet their living expenses. How should they deal with that?

Ibbotson: Well, we still have to buy [bonds]. We still have to include them in our portfolio. They still give you the lower-risk portion of your portfolio. We need balance between stocks and bonds basically whatever else we want to put in our portfolio. How much we put in bonds or even more shorter-term cashlike instruments, they basically stabilize your portfolio and they also behave differently than stocks. Even the longer-term bonds that have some risk in fact have low correlations with the stock market.

So yes, we do need them probably not as much as we've had in the past, but we need them. And also we just have to recognize that we're not going to get the high returns from them.

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