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Bernstein: Short-Term Bonds Are the Least-Bad Choice

Christine Benz

Christine Benz: Hi. I am Christine Benz for here at the Bogleheads Conference, just outside of Philadelphia, and I am joined today by Bill Bernstein. Bill is an author of several books about money and economics and economic history.

Bill, thanks so much for being here.

Bill Bernstein: Pleasure to be here.

Benz: So Bill, I want to talk to you. You are a real asset allocation philosopher. I want to talk to you about what you make of the current bond market environment and investor showing this decided preference for fixed income right now at a time when yields are about as low as they might be able to go.

Bernstein: Well, there has been a lot of talk about being in a bond bubble. I think bubble is the wrong word. I think perhaps bond orgy would be a better way to put it. You know the question is--the first question you have to ask is, is what are these low yields due to and I think part of it is investor preference. But I think the other part, obviously, is the massive amount of purchasing the federal government is doing--quantitative easing or to give it its real name, printing money. I think that the investor has a choice of whether to reach for the yield and go out the duration curve or to take some credit risk or to stay safe. The way I look at it is as a Pascal's Wager, in other words what's the most least disastrous mistake that you can make.

If you believe that inflation is going to heat up and you stay short on your durations and keep your credit quality high and you are wrong, you have lost a couple of percent of yield. Now, that's not good, that's bad. But if on the other hand, you believe that inflation is not going to be a problem and you go out of the yield curve and you lend long with long treasuries and long corporates and you are wrong, and there is inflation and rates do dramatically increase, you will have your head handed to you. So Blaise Pascal, if he were to look at today's bond market, would probably say that the least worst mistake he could make would be to stay shortened and suck it up and accept these low yields and be wrong. I think that's what the rational person chooses to do in this environment.

Benz: So I think about a lot of seniors managing their retirement portfolios and trying to look at the current fixed income environment and think, am I just buying a lot of risk here if I'm moving ever larger shares of my portfolio into fixed income. What's your take on that?

Bernstein: Well, there's been more money lost reaching for yield than has ever been lost to the point of a gun. And again, I think that one of the hardest things to do about investing is the best things to do are often the most uncomfortable things to do, and certainly most uncomfortable thing you can do right now is to buy treasury bills at a dozen basis points of yield. And I think that's probably the smartest course. They're going to get negative yield--negative real returns for a while, they're going to have to start selling some capital to live on, but I think that's a preferable choice to buying longer bonds or taking credit risk and getting egg on your face that way.

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Benz: Okay. So you mentioned inflation protection and the importance of inflation proofing a portfolio or thinking about it when you're managing your portfolio. How much of a portfolio, how much of a fixed income allocation for someone in retirement is appropriate in TIPS versus nominal treasuries and other bonds?

Bernstein: Well, it depends, first of all, upon how much of their assets are sheltered. Someone who has a large amount of assets shelter assets, someone who mainly has a 401(k) or IRAs as their main vehicle can probably own up to, I don't know--10%, 15% of TIPS. But if you want real inflation protection, a short bond does that very well.

If you buy a three-month Treasury Bill or a six-month Treasury Bill, and yields dramatically spike up, guess what? In three or six months, you're going to get the higher yield, and eventually, no matter how much inflation you get, you're going to get positive real yields.

Benz: On the other side of the coin, it seems like right now, maybe a little less so in the past couple of weeks, people are really spooked about deflation, and I am curious to get your take on how fancy people should be about protecting their portfolios against the threat of deflation.

Bernstein: Well, you can't simultaneously protect yourself against inflation or deflation. I suppose you could buy long bonds and you could buy gold. You could invest basically in a Harry Browne portfolio. But at the end of the day, no matter what you buy, some of your assets are not going to do well in that environment. So, it's you can wind up chasing your tail trying to protect against every single eventuality.

Benz: Right. Last but not least, I wanted to talk about this other portion of the portfolio, some people recommend commodities, hedge-like investments. What's your take on whether people need that slice of a portfolio, the alternative slice or do they not?

Bernstein: Well, I see this as an investment industry gimmick. Whenever Wall Street wants to sell you a new asset class, you should hold on tight to your wallet, and I think that's certainly been the case with commodities. The track records of commodities funds, to be quite frank, has been awful. You've been in an environment in which commodities themselves have done really well, but the commodities futures have done very poorly and the reasons for that are very complex, but basically it boils down to all of this money chasing commodities futures has produced negative returns at a time when the returns of the spot commodities have been positive.

When too many people are trying to buy an asset class, when too many people are trying to protect themselves against inflation, or when too many people are trying to protect themselves against deflation, it becomes self-defeating because they bid up the price of those vehicles. About as fancy as I ever get is to recommend real estate investment trusts and to recommend precious metals equities, both of which are very expensive in this environment.

Benz: Right. So, if people are looking at them, they should dollar cost average in or maybe wait for more.

Bernstein: Yeah, the time to buying hurricane insurance is when the sun is shining.

Benz: Right. Well, thanks, Bill. Always great to hear your insights.

Bernstein: My pleasure.