Gauging Bond Risks in the Bucket Portfolios

Holding a cash "bucket" is a key component of the bucket approach to retirement allocation. The idea is that even if the longer-term assets in the portfolio, mainly stocks, sink in value, the retiree will have near-term spending needs set aside in assets that won't fluctuate. That helps ensure a stable standard of living in retirement despite market fluctuations.

But the safety net for my model bucket portfolios doesn't stop with cash; the bucket portfolios also include ample allocations to bonds. The Aggressive bucket portfolios, which are geared toward new retirees who can tolerate some equity-related volatility, feature a roughly 35% allocation to bonds. The conservative versions, meanwhile, target a 60% fixed-income allocation and are geared toward retirees with shorter time horizons (life expectancies) who are drawing heavily on their portfolios for current living expenses. The Moderate portfolios' allocation to bonds falls between the two.

Retirees should customize the size of each of their buckets. But the basic idea behind holding cash and bonds at the front end of the portfolio is that if a retiree encounters a catastrophic market swoon in which stocks drop and stay down for up to 10 years, the cash and bonds will provide a bulwark against needing to sell depressed equity holdings to meet living expenses.

Yet even lower-risk assets aren't without risks. Cash is sometimes called a "risk-free asset," but even cash holdings are vulnerable to inflation. Bonds can run into trouble at various points in time, too. In a recent paper, Morningstar editorial director Tom Lauricella explored considerations for bond investors in four bond-market scenarios. The first is a declining-rate environment, which is usually good for bonds but bad for cash investors. That type of market environment has prevailed for the better part of the past three decades and has made headlines again recently. The second is a rising-yield environment, which crimps bond prices but boost yields on cash and bonds alike. Investors have experienced that type of environment since the Fed began tightening interest rates at the end of 2017. The third is a credit crunch in which the yield differential between low-quality and high-quality bonds widens out; that phenomenon often occurs when investors are feeling nervous about the economy and/or stocks stumble. Finally, the paper looked at what's called yield-curve inversion, which happens when long-term bond yields decline to the point that they're lower than short-term bond yields. Such inversions have historically been a harbinger of economic weakness, usually because investors yields to trend down due to slack economic conditions. Because short-term bonds mature more quickly than long-term bonds, investors demand higher yields from them because they suspect they'll need to reinvest the proceeds into something with a lower yield.

With those scenarios in mind, I decided to take a look at how my baseline model bucket portfolios--both traditional mutual fund and exchange-traded fund--would likely fare. It's a given that the conservative portfolios, which are more bond-heavy, would be most affected by scenarios moving the bond market than will the equity-heavy Aggressive portfolios. But within those portfolios, which of the bond holdings would hold up best and which would tend to struggle?

Running your own portfolio through a similar exercise can help you understand what to expect from your own bond holdings and rightsize the risks you're taking. That way, you're likely to sit tight through inevitable market changes.

Scenario 1: Federal Reserve lowers interest rates. This is the scenario that many bond-market watchers expect to unfold later this year, especially if economic data continue to point toward softening in the economy. While the Federal Reserve held its benchmark interest rates steady at its most recent meeting, it has indicated that it may take a more dovish stance than it has in the recent past. That could prompt the Fed to reduce the federal-funds rate, which is the overnight borrowing rate that the Fed charges banks; when money is cheaper, that tends to stoke the economy by encouraging lending and borrowing.

Within my model portfolios, the biggest loser in a declining-yield environment will be the cash holdings. As the Fed embarked on a series of interest-rate cuts during the wake of the financial crisis, for example, cash yields plummeted from more than 5% in 2007 to barely positive by early 2009. (My model bucket portfolio "stress tests" tell the tale.) The fact that cash yields are still pretty low and could go lower is one reason why it's important to not go overboard with cash holdings in an in-retirement portfolio. My bucket portfolios call for holding two years' worth of portfolio withdrawals in cash, but one could reasonably opt for a single year's worth. (Financial planner Harold Evensky noted that he uses a one-year cash allocation for his clients.)

Meanwhile, Fed easing tends to be a boon for bond prices. The principles of the duration stress test will operate in reverse, with yields declining and bond prices gaining. The longer the duration, the bigger the gains.

As cited in the paper, the Morningstar Investment Management team believes there are structural forces that are keeping interest rates down, not just in the United States but globally. Those forces include an aging population, longer life expectancies, and higher savings rates in emerging-markets economies. All of these secular factors tend to stoke demand for bonds and other savings instruments, pushing yields down. Nonetheless, I've avoided long-term bonds for the model portfolios. While they may be the biggest beneficiaries of declining yields, they're also incredibly volatile, leading to performance that's not very bondlike.

Scenario 2: Federal Reserve increases interest rates. In a rising-yield environment, cash investors will be the near-term winners as higher yields come on line. Bond prices will suffer a short-term dislocation, with the longest-duration bonds most vulnerable during such a period, but over time, bond investors stand to benefit from higher yields. Bond investors should run the bond holdings in their portfolios through a duration stress test. That means subtracting SEC yield from duration; the remainder is a rough estimate of what that holding would likely lose in a one-year period in which interest rates trended up by 1 percentage point. The first quarter of 2018 provides another window into bond-fund performance in an interest-rate shock. Long-term Treasuries, among the most interest-rate-sensitive of bond types, lost about 4% in that period, whereas the Bloomberg Barclays U.S. Aggregate Bond Index lost just 1.5%.

None of the holdings in the model portfolios, either mutual fund or ETF, court substantial duration risk; even the intermediate-term bond funds have durations of less than six years. The longest-duration fund in the portfolios is the bond sleeve of Vanguard Wellesley Income VWIAX, at nearly seven years. Morningstar has long flagged that as a potential risk factor for the fund. In addition to its interest-rate sensitive fixed-income portfolio, its focus on dividend-paying stocks contributes to its sensitivity to rate changes. Nonetheless, the fund has historically been a strong performer in a variety of market environments.

Scenario 3: Credit spreads widen. When credit spreads widen, investors begin demanding a higher yield for lower-quality bonds than they did in the past. That tends to push down lower-quality bond prices while the highest-quality bonds might get a boost. Credit spreads have been quite narrow for most of the past decade, as absolute yields across the board remain low and investors have appeared comfortable with the economy's prospects. However, yield spreads widened dramatically in the fourth quarter of 2018 when tariff worries stoked concern about the economy and equities tanked.

As you might expect, the low-quality bond components of the portfolios--high-yield bond and bank-loan funds--would fare the worst in such an environment. In 2018's fourth quarter, for example, Vanguard High-Yield Corporate VWEAX and Fidelity Floating Rate High Income FFRHX, the two low-quality representatives in the mutual fund and ETF portfolios, lost 4.4% and 3.4%, respectively, during the quarter.

Meanwhile, the highest-quality bonds will inherently perform best in such an environment. Not only will there be increased demand for them (their prices go up and their yields go down). But if the catalyst for the credit spread widening is serious enough (usually signs of economic weakness) investors may begin to expect the Fed to take action to reduce interest rates to stoke the economy. Government-bond and Treasury bond funds will tend to perform well in such an environment; total bond market index trackers, which are roughly two thirds government bonds, will also perform well. My mutual fund portfolios use an actively managed fund, Harbor Bond HABDX, for their fixed-income exposure and might thus benefit a bit less from widening spreads than a total bond market index tracker. It lands in the new intermediate core-plus bond Morningstar Category, which features funds with heftier allocation to lower-quality bond types than the intermediate core bond group. Ditto for iShares Core Total USD Bond Market ETF IUSB, the core fixed-income position in the ETF portfolios. That fund has a dash of bonds rated below-investment-grade (about 8% of assets) and an average credit quality of BBB--investment-grade, but barely. Thus, it will underperform a total bond market index in a period of widening spreads. On the flip side, its yield and in turn its return has historically been a bit higher than a total bond market index

Scenario 4: Yield-curve inversion. Normally, investors demand a higher yield for holding long-term bonds than they do for short-term bonds; after all, long-term bonds require that they tie their money up for longer, so it only makes sense that they should offer more compensation. Yet the yields on long-term Treasury bonds dropped below those of short-term Treasuries in late 2018, prompting widespread consternation that a recession could be in the offing.

In the short-term, yield-curve inversions can present an opportunity, in that it's possible to obtain as high a yield on short-term bonds than long-term ones. However, the key reason that short-term yields spike is that investors know that when their bonds mature, they'll have to reinvest them into a lower-yield environment.

In a yield-curve inversion, stocks will typically behave worse than bonds, in that investors are signalling that they see economic weakness on the horizon. Indeed, in the fourth quarter of 2018, the Aggressive portfolios, which feature more than 60% in equities, fell more than the Conservative and Moderate versions.

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