Friday, January 11, 2013

How We Use Bonds

Typically, investors hold bonds in their portfolio to mitigate the volatility of stocks.  While bonds may reduce the portfolio volatility and drawdowns of a stock portfolio somewhat, it would take an extremely large bond allocation, along with an extremely large reduction in potential portfolio returns, to have any meaningful impact.   

Reducing Portfolio Volatility and Drawdowns--The Traditional Approach

Very few investors can tolerate the volatility and drawdowns of a portfolio that is 100% weighted towards stocks.  From October 2007  to March 2009 a portfolio invested solely in the S&P 500 would have endured a 60% drawdown.  Not many people could endure that kind of loss without selling in a panic.  Bonds are often not correlated with stocks, especially during market downturns, and they typically are not subject to the same magnitude of drawdowns that stocks are (depending on the type of bond of course).    In this case, adding bonds to a portfolio would likely reduce volatility while also reducing returns.  For example, in 2008 the S&P 500 Index dropped 37% while the Barclays Aggregate Bond Index ETF (AGG) increased 7.57%.  An investor who had a portfolio that was 60% in the S&P 500 and 40% in the AGG would have lost about 20%.  This is better than losing 37% but it is still an unacceptable loss.  During up years for the market this same investor is likely to give up a lot of market upside for not much protection on the downside. 

Investors will often think of bonds as risk free or near risk free.  Bonds have been in a bull market (caused by a steady decline in interest rates) since 1982, this covers the entire investing experience of most investors today.  If they have never seen a bear market in bonds they start to believe that it can't happen.  Bond prices move inversely with interest rates, if interest rates rise then bond prices will go down.  Nobody can predict whether interest rates will rise in the future but common sense suggests that they will.  The Federal Reserve has been artificially keeping rates low since the 2008 crisis, this will not last forever.   Traders also make decisions on whether to allocate money to stocks vs. bonds based on risk and return.  In times of high interest rates and/or financial crisis, traders move money to bonds.  In times of low interest rates and rising stock prices, money flows to stocks.  As the stock market continues to recover from the 2008 crisis, more and more money will flow out of bonds, causing prices to go down, and into stocks. 

Bonds can also decline in value for other reasons besides interest rates.  Higher yielding areas of the bond market, such as high yield and emerging market bonds, had drawdowns of 25%+ during 2008. 

Reducing Portfolio Volatility and Drawdowns--The TTM Approach

Instead of having a fixed allocation to bonds that could-----decrease portfolio drawdowns somewhat, decrease portfolio returns, and lose value when/if interest rates rise----we maintain a tactical allocation.   When our momentum measures show that bonds are stronger than stocks this indicates that the risk of a decline in stocks is high and the potential rewards are low.  In this instance we can shift all the way to 100% in bonds.  Not only would this enable us to reduce drawdowns substantially during bear markets, it also allows us to potentially make money in a market downturn.  When momentum shifts back towards stocks it indicates that the potential rewards in the stock market are high and the risks of a decline is not as high.  In this case we can move out of bonds and go to 100% stocks, avoiding the drag on portfolio returns that comes from owning bonds. 

If our momentum measures favor bonds over stocks, then a decision must be made about which bond sector(s) we should allocate to.  Typically, we only use bond sectors that are easy to buy and sell through actively traded ETFs---investment grade corporate, high yield corporate, emerging market, Barclays Aggregate Bond Index, Treasury Inflation Protected Securities (TIPs), and/or Treasury Bonds.  During times of great market turmoil, Treasury Bonds tend to be the best bond sector as traders prefer the perceived safety of Treasuries, regardless of interest rates, to the risk of stocks. 

At some point the bull market in bonds will end---for it to continue interest rates need to decline from here which is possible, but not likely.  Once it ends, investors that have fixed allocations to bonds will suffer losses.  Until it ends, it is likely that bonds will drag down portfolio returns as a major part of their return comes from interest rates, which are currently low.  By using bonds tactically to hedge whether they are in a bull or bear market is irrelevant.    Regardless of the level of interest rates bonds are a safe haven at times of turmoil in stocks.  Investors are willing to earn very little, if anything, in bonds to avoid potential losses in stocks. 


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