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Investing Specialists

The Buckets Are Working

Bucket 2 has sprung a small leak recently, but cash holdings are proving their mettle.

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Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Bucket 1 was tailor-made for times like these.

That’s what I was thinking as I surveyed the recent performance of my bucket portfolios--mutual fund and exchange-traded fund portfolios geared toward investors who are actively withdrawing from their portfolios.

Not surprisingly, Bucket 3 has been awful: That’s the equity portion of the portfolios. Giving the portfolios a generally high-quality emphasis has helped a bit: For example, Vanguard Dividend Appreciation (VDADX)/(VIG), the top holding in my core mutual fund and ETF portfolios, has lost less than its peers, thanks to its focus on high-quality companies and light weightings in the hard-hit financials and energy sectors. But its outperformance has been strictly relative: Almost nothing in the equity market has escaped bruising losses. 

More worrisome is that Bucket 2, which consists of high-quality fixed-income investments, has recently sprung a small leak, too. While high-quality bonds had proved their mettle in the early days of the market sell-off, gaining small amounts even as stocks declined, more recently they’ve posted small losses. That’s largely because the spread--or yield differential--between corporate and Treasury bonds has widened, meaning that corporate bond prices declined. For example, total-bond-market index funds lost nearly 1% on Thursday, March, 12, and more corporate-bond-heavy products, such as those in Morningstar's intermediate-term core-plus category, lost more still.

The good news is that Bucket 1--the cash component of the portfolios--earns its keep in times like these. For investors who are using the bucket approach to manage their in-retirement cash flows, Bucket 1 serves a few separate functions. First and foremost, it’s there to provide cash flows on an ongoing basis, helping to ensure that a retiree doesn’t need to tap stocks or even bonds while they’re down in the dumps. Moreover, it provides a valuable intangible: peace of mind. The type of volatility we’ve experienced recently is unsettling for retirees, in that they’re drawing upon a pool of finite resources. Holding cash helps ensure that retirees can ignore the market turmoil (as much as that's possible) and carry on with their lives.

Opportunity Cost of Bucket 1 Varies
This isn’t the first time the value of Bucket 1 has come to the fore. In 2018, a year in which bonds barely eked into the black on a total return basis and stocks posted losses, the cash component of the bucket portfolios was the best-performing holding in all of my model bucket portfolios.

More typically, holding cash has hurt the portfolio’s returns relative to a fully invested stock/bond portfolio (Buckets 2 and 3) that doesn’t hold cash. In a “stress test” of my model portfolios, I back-tested the three-bucket portfolio relative to one with stocks and bonds only. Not surprisingly, given that investors are usually rewarded for taking risk, the fully invested version outperformed the three-bucket portfolio over the nearly 20-year time horizon that I examined. That result is apt to look even more clear after 2019, when stocks and bonds both enjoyed stellar gains but the poor cash investor had to settle for ever-lower yields.

That said, the opportunity cost of enlarging Bucket 1 seems especially low right now. That’s because yields on cash investments are hardly exciting, but they’re close to--or in some cases in excess of--what bond investors are earning today. For example, a survey of high-yield savings accounts available on bankrate.com shows many accounts yielding 1.5% or more. That's not great, but it’s better than the yields on many bond funds. Cash also offers guaranteed stability of principal--something bondholders don’t enjoy. For that reason, I wouldn’t quibble with investors allocating a bit more to Bucket 1 than the two years’ worth of cash flows I normally recommend, especially if they already have the money in cash and wouldn’t need to pull from depressed asset classes to do so.

What's Up with Bucket 2?
I’ve been keeping a particularly close eye on Bucket 2 during the recent turmoil. In most of my model bucket portfolios, I’ve organized this portion of the portfolio by risk level: a high-quality short-term bond fund at the front of the queue, followed by Treasury Inflation-Protected Securities (short-term, if available), and a core- or core-plus intermediate-term bond fund. I’ve also included a small dash of equity exposure in the portfolios, and in some cases small positions in floating-rate funds.

The holdings in Bucket 2 are meant to serve as next-line reserves in case Bucket 1 is depleted and the retiree needs to source additional cash. None of the holdings in Bucket 2 is guaranteed, in contrast with the cash holdings. But high-quality short-term bonds, especially, are unlikely to experience meaningful losses. Over the past 38 years, short-term bond funds have posted positive returns in 94% of 12-month rolling periods. And in 12-month periods when such funds have lost ground, more than half of the time they’ve lost less than 2%.

True to form, the high-quality short-term bond funds in my bucket portfolios have held their ground nicely during this period of extreme volatility. Intermediate-term bonds haven’t fared as well. Not only has interest-rate sensitivity been punished, but the aforementioned widening of credit spreads has also hurt holdings like Fidelity Total Bond (FTBFX), a core-plus fund that’s a holding in the Fidelity bucket portfolios.

For the ETF bucket portfolios, it’s also worth noting that bond ETFs have recently experienced an odd gap between their market prices (the prices investors are willing to pay for the basket of bonds) and their net asset values (the value of the bonds in the portfolio). For example, on March 12, iShares Core Total USD Bond Market ETF (IUSB) lost 3.75%, even as plain-vanilla bond index mutual funds lost about 1%. Part of that stems from the iShares fund's exposure to lower-quality bonds. In addition, the market prices of many bond ETFs dropped lower than their NAV prices that day. Morningstar’s director of global ETF research, Ben Johnson, believes that disconnect could owe to the fact that ETF prices might be directionally more accurate than the values asset managers are receiving from their third-party pricing vendors. In other words, the ETFs’ prices are a truer reflection of the value of the bonds in the portfolio, and the NAV hasn’t yet caught up. Of course, this issue matters only to ETF investors who were buying or selling during this period, but it’s something our team of passive strategy researchers continues to monitor closely.

Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.