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What to Do With Bonds Today

Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. I'm here at the Bogleheads Conference, and I'm joined today by investment expert Rick Ferri.

Rick, thank you so much for being here.

Rick Ferri: Thank you, Christine, for having me.

Benz: Rick, I'd like to talk about bonds and how investors should be approaching bonds at this juncture. There has obviously been a lot of consternation about the asset class, and one strategy that I've heard from investors is that they are just going to hunker down in short-term bonds or maybe even cash until this whole thing blows over. What do you think about that as a strategy?

Ferri: So, the strategy of lowering your duration or the maturity of your portfolio based on a person's expectation of higher interest rates, I would assume, then that person would then get back into bonds at some time, so it really is requiring two trades, if you will. One, when am I going to get out to get into short-term? And then two, when am I going to get back in? The probability of being right with both of those is very low.

So, what if you just stayed intermediate-term during the whole time? During this whole period since 2008, when interest rates literally want to zero, what if you just stayed intermediate-term and picked up 2% or 2.5%? Well, if you accumulate that over the last five to six years, you've actually picked up 10% to 12% extra in your portfolio if you didn't make the assumption that interest rates were going to go back up and, therefore, you are going to get hurt. In other words, this is called opportunity cost.

If you make this determination to get out of intermediate-term bonds and go into short-term bonds and then go back into intermediate-term, that's an opportunity cost. I think that people who have talked about and done this have really risked their portfolio and have lost out because they've missed the opportunity to get intermediate-term bond yields. I've never been an advocate of lowering your portfolio unless you needed to, because you're going to be taking the money in the next couple of years. That's a different story. That's a need-based thing. It has nothing to do with the yield curve.

I'm not in the camp of "lower your maturities and get ready for higher interest rates." I have never believed that, and I've never been in that camp. And it may happen--I don't know when--but in the meantime, if you do it, you're missing out on some pretty decent yield from intermediate-term.

Benz: When we look at fund flows, another area where we see very strong investor appetites is in the area of more credit-sensitive bonds--high-yield and bank loans, and maybe even emerging-markets bonds. How do you think about those asset classes? How should investors be approaching them at this juncture?

Ferri: So, you're really speaking about high-yield corporate?

Benz: Or bank loans or emerging-markets.

Ferri: Well, bank loans are high yield.

Benz: Yes.

Ferri: Just a different type. People are stretching for yield because they want to get the income. And I think that having an allocation to high-yield is good. In my bond portfolio, I've always had a 20% allocation to a low-cost, high-yield bond fund.

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Benz: This is your personal portfolio or your client portfolio?

Ferri: No, this is a client portfolio. And full disclosure, I used the Vanguard High-Yield Corporate Bond fund (VWEHX) for that. And it's very low cost and you get broad diversification and BB and single B rated securities, which is not included in a total bond market index fund. So, you're actually diversifying your bond holdings more if you have a total bond market index fund and then a little bit of high-yield. But it's a fixed allocation.

If yield spreads on high-yield come down and the value of high-yield goes up, there is a rebalancing done to take some money out of high-yield and put it into investment-grade. Vice versa, like we saw in 2008, when credit spreads really widened and the value of the high-yield bonds go down, you are taking some money out of investment-grade and you're putting it into high-yield. So, you are getting an extra benefit from even doing that.

So, I'm all for taking some credit risk in a portfolio because you are rewarded for taking that extra risk. The question is doing it judiciously and in a small amount. And I think that a 20% allocation to high-yield corporate bonds is a good allocation.

Benz: I assume you've been trimming recently or you have over the past few years.

Ferri: Sure. As the spreads between high-yield and investment-grade shift way up and then shift way down again, it causes the value of high-yield bonds to go up or the high-yield bonds to go down, and therefore, you need to do a rebalancing to keep your 80%/20% mix. And I've been doing it that way for 15 years, and it's worked out well.

Benz: One other strategy that I frequently hear about--from retirees especially--is that they are going to forget about bonds and just invest in dividend-paying stocks and use those for their income on an ongoing basis. The idea is that bonds aren't a particularly attractive asset class right now.

Ferri: Well, I follow with you all the way to the point of "unattractive asset class," because that becomes sort of a market-timing move. To do high dividend-yielding stocks, if that's your long-term strategy to get income out of a portfolio and you're going to do it with discipline and you're not going to try to time these markets and all that, if that's your strategy, as long as you do it in a very low-cost and widely diversified way, fine. That's your strategy for implementing your retirement and how to get the money out.

You are, in many cases, depending on what index you use for the dividends, you might be highly concentrated in some industry sectors. So, I would say you pick your dividend-producing fund well, where you're widely diversified. Now, if you're widely diversified amongst different industries, you are going to be giving up some yield, but you can get a little bit higher dividend flow from some of these products that are out there.

It is a value strategy, so it's not going to track the stock market. You're going to have some years where you're going to underperform. But if all you're looking for is the cash flow from the dividends--and this is going to be your strategy for retirement--there is nothing wrong with that as long as you maintain the discipline for the very long term and don't try to time these things.

Benz: Of course, you'll see your principle get buffeted around a little more than would be the case if you had a fixed-income allocation.

Ferri: Yes, because stocks are more volatile than bonds, so you're going to get banged around a little bit. But what you're going to get in return is a rising dividend yield. So, unlike bonds, as companies make more money and pay higher dividends--or maybe they buy back stock and they push up the dividends that way somehow--you're going to get a higher cash flow over time. I think dividends, over the long term, increase by about 2% to 3% per year and faster than that in the last few years. So, that's nice to get that rising dividend stream. So, again, you give up something--you have more volatility. But you get something--you get a rising income level to maybe offset some inflation. So, a benefit to everything.

Benz: Another topic I'd like to get your take on is the role of global diversification in fixed-income portfolios. Vanguard has obviously embraced this concept in a big way, adding global-bond exposure to all of its target-date funds. I'd like to get your take on whether global-bond exposure is a must-have for all investor portfolios.

Ferri: Do I see foreign bonds as a must-have?

Benz: Yes.

Ferri: No, I don't. I don't see them as a need-to-have. To me, if you've got foreign bonds and then you're going to hedge out the currency risk, what you're left with is a coupon minus the currency risk of the interest payment. And because the cost is higher to do foreign-bond investing, both the fund fees are higher and then there is the overlay of the currency hedge--and that adds a cost. You're really, in my opinion, better off just sticking with a diversified portfolio of U.S. bond index funds, because the costs are lower.

I know there is a benefit, a very slight benefit of having some foreign-bond exposure in a U.S. bond portfolio, if there is no cost to it. But once you start adding the cost, I think you're getting to the point where there is no benefit because the costs are that much higher. Now, we're splitting hairs. So, if you want to have foreign-bond exposure in your bond portfolio--maybe 10%, whatever it is you want to have--I'm not going to argue with you. It's just that, from an academic standpoint, I don't see the benefit because, even though the costs are fairly low in a Vanguard fund, they're still higher than U.S. bonds. And in the end, you are just buying a coupon. So, you are still better off just in U.S. bonds than adding foreign to it, in my opinion.

Benz: How, in your view, should investors be approaching fixed income with their portfolios today? I'd like to hear about your client portfolios. I know you said you use the 20% high-yield piece; I know you also have an allocation to Treasury Inflation-Protected Securities. How does it all come together?

Ferri: That's a good question. I start out with the total bond market index fund, very low-cost Treasuries, corporates, asset-backed. Actually, there's some foreign-bond exposure in there, Yankee bonds, which are foreign bonds that are denominated in U.S. dollars and trade here. So, you are getting foreign-bond exposure right there. Also, in mortgages. So, you get this 60% allocation of investment-grade U.S. bonds. Now, they call it the total bond market, but in fact it's not. It's missing two important elements to it.

One on side, it's missing high-yield bonds. High-yield bonds are not part of the total bond market index, or an index fund. And on the other side are TIPS, Treasury Inflation-Protected Securities. Those are not included in the [Barclays U.S. Aggregate Bond Index]. So, if you want to have a total U.S. bond market portfolio, you need to add an element of high-yield and you need to add an element of TIPS.

Now, how much of each one? Well, that varies based on the market, but what I've always done is taken an allocation of 20% into high-yield using the Vanguard High-Yield Corporate Bond Fund and then 20% in TIPS. And, here, you can use either the Vanguard fund or there are some ETFs out there that are very low cost as well. And that gives you 20% high-yield, [60%] investment-grade total bond market, and 20% TIPS. And then you do a rebalancing between that strategic allocation when needed, and that's worked out well for me. So, to me, it's been a good portfolio to have. I've had it for many, many years. I haven't changed it, and I don't see a need to change it.

Benz: The TIPS asset class seems like one of the most unloved right now. Inflation is really benign. Let's talk about why you continue to believe that an allocation to TIPS make sense for investors. And also, there, are you using the core TIPS fund or are you using the new short-term TIPS fund?

Ferri: Good question. TIPS are not there to produce income. TIPS are there to protect against a very specific risk, and that risk is unanticipated inflation. So, you've got your investment-grade bonds and you've got your high-yield bonds, and they are coupon-bearing. And there is an inflation expectation built into that. But if inflation jumps 2% or 3% in one year, unexpectedly, those portfolios are going to be harmed, whereas the Treasury Inflation-Protected portfolio should actually increase in value because of the unexpected jump in inflation. So, it's a hedge against that. It's a very specific risk factor that I'm trying to hedge out with the 20% TIPS.

I don't use the short-term TIPS fund. Again, I think that that might be appropriate for somebody who needs the money in the next year or two or three; but for retirees or people who are saving for retirement and you have long liabilities down the road, you just use the regular intermediate-term TIPS fund.

Benz: So, you get a lot of interest-rate-related volatility with that core TIPS product, correct?

Ferri: You get intermediate-term duration risk, which is interest-rate risk. That's correct. But that's OK, because if you are going to live for another 25 or 30 years and you're going to be taking money out of your portfolio for 25 or 30 years and then maybe you want somebody to inherit the rest, these liabilities are way out there. So, the fact that you might have some interest-rate risk in the portfolio is not a major factor because your liabilities are so far out.

Benz: Rick, thank you so much for being here. It's always great to hear your insights.

Ferri: Thank you for having me, Christine.