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By Christine Benz | 10-17-2013 12:00 PM

These Income Strategies Have Drawbacks

Vanguard's Fran Kinniry urges yield-seeking investors to use history as a guide and focus on total return instead of taking on equity and credit risk associated with popular income-producing strategies.

Christine Benz: Hi, I’m Christine Benz for I recently visited Vanguard where I sat down with Fran Kinniry, a principal in Vanguard’s Investment Strategy Group. We discussed the pitfalls associated with some of the strategies that fixed-income investors have been using lately.

Fran, thank you so much for being here.

Fran Kinniry: Thank you, Christine.

Benz: Investors who are using a strategic, buy-and-hold, rebalancing program probably look at their allocations and see that they're heavy on stocks, light on bonds relative to their targets. But investors do have some trepidation about taking from their equity holdings and adding to bonds at this point. What do you say to investors who are looking at their portfolios knowing they should rebalance but maybe are hesitating to pull the trigger and do it?

Kinniry: I think most investors always struggle with rebalancing because in the moment, real time, there is always a back story. Think back to 1999, there was the new paradigm, Dow 36,000. We all knew equity allocations went up pretty strongly, but very few investors were rebalancing then. We have to go back to think about how we were feeling at the end of 2008 or the beginning of 2009, when the stock market was just off 55%, and again, we saw very few investors rebalancing. Most of the flows were in bonds. And now again today we see the stock market up 185%. Everyone's expectations are that interest rates will rise. And so, it's hard to get people to take money off the equity side and put it into bonds. But history as a guide is really the prudent way to manage your asset allocation.

Benz: You mentioned, Fran, this interest-rate shock that everyone is expecting--and we did have a little bit of a taste of it back in the early summer where we saw rates shoot up quite a bit in a short period of time and certain fixed-income asset classes were hit pretty hard--but this, I think, is warning some investors off of bonds. So, not only are they hesitant to trim their equity holdings, but they're just not that excited about the prospects for bonds on a forward-looking basis.

Let's talk about the real risks for bonds. You recently did a research paper where you examined past bear markets for bonds and compared them with bear markets for equities. You found they're quite different animals.

Kinniry: Yes, not only in frequency. I think people may forget that the stock market has a negative return 25% of the time, one out of every four years. But the magnitude, how much you've lost in the stock market, is significantly different than the bond market.

You mentioned the early blip from May through the end of the summer; interest rates went up by 84 basis points, so almost a 1% increase in bond yields from a very low handle. That would rank as one of the biggest moves on an annual basis. Yet, the bond market at the time was only down 4% or 5%. A bear market in bonds tends to look like single digits, 4% to 8%, maybe 10% at the worst, whereas with a bear market in stocks, [we had] many episodes of negative 20%. And we just had two episodes within the last decade of down 40% and down 55%. So, the magnitude is significantly different, and we just want to make sure investors understand that.

Benz: What about people though who might ask how instructive past performance is in bonds given that we've had almost three decades worth of a generally declining rate environment?

Kinniry: I would say, first, everyone has to recalibrate themselves. The real return, which is the return over inflation on bonds has been anywhere between 2.0%-2.5%. And so, let's say inflation expectations as measured by Treasury Inflation-Protected Securities, or most expectations again are about 2%. Bonds aren't that far from their normalized return. If you take 2.0% to 2.5% of a real return, put that on top of inflation of 2.0% to 2.5%, normal bond yields are maybe 4.0% to 4.5% today. So let's play that out. Let's say we're at 3.0%, and we go to 4.5%. That's a 1.5% increase. 

Duration on intermediate-term bonds, let's just use round numbers, is 5 years, so you'd lose 5%, and then add 2.5% to get 7.5%. But you have your coupon, your yield of, let's say, 3%. So your total return, we're right back to that 4.5% number.

Even if we forget the past and move forward, run interest-rate scenarios of where you think interest rates are going to go, multiply that by the duration, don't forget to add back in your yield, and you can see that it's hard to find too many environments where you would lose anywhere close to stock market-type losses.

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