Don't Let Your Portfolio's Insurance Lapse

Savvy household financial managers would never let their homeowners or auto insurance lapse, or spend a minute without health insurance.

But some investors seem more than willing to let the insurance on their portfolios lapse. By "portfolio insurance," I'm not referring to the shorting strategies that some institutional investors use, or overwrought annuity products designed to limit investors' downside (while also taking away a good chunk of the upside).

Instead, I'm talking about bonds--plain-vanilla high-quality bonds and bond funds. True, inflows into high-quality core bond funds have been positive over the past year. But when I'm out and about talking to investors, I still hear plenty of skepticism about why they should bother with them. Put off by meager yields and spooked by the prospect of rising interest rates, investors tell me they're forgoing high-quality bonds in favor of other sources of yield--dividend-paying stocks, preferred stocks, and high-yield bonds, for example. We even see signs of this in professional investors' behavior: Many balanced funds, for example, have been venturing into junkier and junkier portfolios.

Some of these securities may, in fact, hold up better than high-quality bonds when interest rates begin to trend up. But they aren't likely to perform as well as boring, old high-quality bonds in an equity-market shock. And that diversifying ability--that ability to hold up well or even gain ground when stocks are in the dumps--is the saving grace for high-quality bonds right now. In short, they're the insurance policy for the high-value part of investors' portfolios--the equities that have appreciated so nicely over the past six years. And with equity-market valuations as high as they are currently, the risk of such a shock is arguably higher than the risk of a giant jump up in interest rates that would decimate bond prices.

Why (Almost) Everyone Hates High-Quality Bonds To be sure, high-quality bonds' days as a return engine for investors' portfolios are numbered, so investors will want to ratchet down their return expectations accordingly. As a general rule of thumb, investors can expect to earn their bonds' starting yield over the next decade--nothing more, nothing less. With the Barclays U.S. Aggregate Bond Index currently yielding less than 2%, investors in a fund tracking that benchmark will be lucky to break even with inflation over the next 10 years. A reprise of the last 25 years, in which the yield on 10-year Treasury bonds dropped from 8% to less than 2% today, boosting bond prices along the way, is extremely unlikely.

Instead, high-quality bond prices are likely to get buffeted in the other direction, by rising yields. And the fact that yields are meager to start with gives high-quality bonds less of a cushion under that scenario. In a one-year period in which yields rise by one percentage point--a sharp jump up, to be sure--investors can expect to lose roughly the amount of their duration, less their yield. For the Aggregate Index holder, that would translate into a roughly 3.5% loss over such a period (the index's duration of 5.5 years minus its current yield of 2%).

Haters Don't Hate So, those are the drawbacks. The lone benefit--but an important one--is that high-quality bonds are apt to hold up better than other securities in investors' portfolios, and perhaps even better than cash, in a period in which stock prices are punished, if history is any guide.

In 2008, for example, a portfolio with 60% in the S&P 500 and the remaining 40% in the Aggregate Index would have lost 22%. As investors fled to the perceived quality and safety of high-quality bonds during that period, a 5% gain in the bond piece took the edge off a 37% decline in such a portfolio's equity component. Meanwhile, the portfolio divided between stocks and a basket of junkier bonds would have fared much worse. A 60% S&P 500/40% multisector-bond portfolio would have lost about 30% during that year, for example. A portfolio focused exclusively on high-quality dividend-paying equities (and eschewing bonds altogether) would have also posted losses of about 30%--or even higher if it had emphasized the hard-hit financials sector at the outset of the crisis.

Of course, investors are wise to question whether the next equity-market shock will go down the way the last one did. Will high-quality bonds step up and fulfill the same role they did in the last stock market rout? There are no guarantees, of course, and bonds are arguably as richly valued as stocks right now. If stock prices tumble because interest rates jump up more quickly than expected, high-quality bonds will likely behave badly, too. But in a scenario under which fearful investors flee risky assets, there are intuitive reasons to believe that high-quality bonds that have a high probability of paying their coupons will enjoy a pickup in prices at a time when all other bets are off.

What to Do Even if investors haven't been banishing high-quality bonds from their portfolios, there's a good chance that they've let them drop in importance as a percentage of their portfolios as equities have appreciated. A portfolio that was split equally between stocks and bonds at the outset of the current equity-market rally (early 2009) would be more than two thirds equity today. That means that rebalancing should be on the to-do list for many hands-off investors, especially those who are nearing retirement. Bad sequencing risk--the chance of encountering a lousy market environment at the outset of retirement--is a realistic possibility for many would-be retirees today, given not-cheap equity valuations.

Even if investors' stock/bond mixes are in line with their targets, they should take care to ensure that they haven't been pursuing "faux diversification"--buying lower-quality bonds in lieu of high-quality exposure. Lower-quality bonds have higher yields and may well perform better than high-quality bonds in an interest-rate spike, but they won't act as an insurance policy in an equity-market sell-off. This article discusses how low-quality bonds often perform more in line with stocks than bonds and, therefore, are a less-than-optimal source of diversification for equity portfolios.