The Case for Minimizing Risk in Your Bond Holdings
The sky didn’t fall, after all.
At its September policy meeting, the Federal Reserve decided not to raise interest rates. Had it done so, higher rates would have translated into a loss of principal, at least on paper, for bondholders. (When interest rates rise, bond prices fall.)
But the apparently misplaced obsession with the Fed misses a larger point: A substantial rate rise isn’t the only way bonds can bite you. The other major danger is credit risk—that is, the possibility of default. And in my opinion, this is just as serious a threat to your nest egg.
Over the very long term, the markets reward taking credit risk, but not by nearly as much as you might think. From the start of 1926 to Sept. 30, 2015, for example, long-term corporate bonds returned an annualized 6.00% on average, compared with 5.62% for safer long-term U.S. government bonds.
And this thin margin over the long haul disguises occasional short-term costs—sometimes substantial—for owning corporate bonds rather than government bonds. In the first 10 months of 2008, for instance, long-term corporates lost 15.8%, while long-term government bonds eked out a 0.3% positive return.
The message is crystal clear: Financial risk isn’t just about the possibility of sustaining significant losses. It’s also about the possibility that those losses show up when you can least afford them, as they did for many investors in the dark days of 2008 and 2009.
The risk in your portfolio belongs on the equity side; the bonds in your portfolio are there for safety, not yield. They’re the dry powder that will see you through tough economic times and enable you to scoop up stocks at the accompanying fire sale; if they’ve taken a big hit along with your stocks, they won’t do you much good.
This is why I believe in avoiding credit risk in your fixed-income portfolio—not just corporate bonds, but lower-grade and longer-term municipal bonds, too, which also got hammered during the last crisis, mainly because of their limited liquidity.
This, in turn, informs the choice of fixed-income assets. Since so-called total bond index funds—which, to varying degrees, reflect the broad bond market—consist mainly of high-grade government debt, they’re dandy for the fixed-income pool of the average investor. But with a little effort, you can do better.
To see just how badly credit risk can bite even a total bond index fund, we’ll focus again on the first 10 months of 2008.
Let’s look first at the Barclays U.S. Aggregate Bond Index, the benchmark for most total bond index funds. During that period, the total return for this index, which includes corporate as well as Treasury bonds, was negative 3.2%—not horrible, and certainly a lot better than equities did then. On the other hand, a Barclays index of intermediate-term Treasury issues with roughly the same average maturity had a positive return of 5.3%.
But woe unto those who reached for yield by focusing on corporate bonds. A Barclays index of high-grade, intermediate-term corporate bonds returned negative 11.6%, and a Barclays index of intermediate corporate bonds that concentrates on notes below investment-grade status returned negative 23.7%.
My advice: Avoid, if possible, bond funds altogether, in part to save yourself the fees, and I would limit my fixed-income holdings to those with a government guarantee—Treasurys and certificates of deposit (assuming you stay below the $250,000 guarantee limit for the latter). Pick an average maturity that reflects your risk tolerance and start a ladder—a range of holdings with staggered maturities, which gives you the opportunity to reinvest money from maturing securities as you see fit, or take the cash if you need it, at regular intervals.
Let’s say that because you’re worried about the prospect of rising interest rates, you want to keep the average maturity of your holdings at two years or less. Purchase equal amounts of one-, two- and three-year Treasurys and CDs, and roll the securities that mature each year into new three-year securities; that way you’ll always have some holdings maturing every year.
If you need cash to live on or to buy stocks on the cheap, you can sell the Treasurys. CDs are more costly to liquidate, particularly if they’re in a brokerage account, but you can cash out of them as they mature rather than roll them over.
You come out ahead in a couple of ways with this strategy, as opposed to buying a bond fund. First, if you never have to sell a CD before maturity, you’ll earn about 0.6 to 0.7 percentage point more on them in annual yield than you would on a Treasury of comparable maturity. And second, why pay even the slimmest of fees on a bond fund when you can buy Treasurys at auction at no cost? (You can buy bonds at auction without fees at the government website TreasuryDirect.gov or, with a large enough account, at many discount brokerage firms.)
Not for everyone
There are a few caveats and wrinkles here. In most cases, you’ll need at least a $100,000 portfolio to make this strategy worthwhile (especially if you’re paying even a small brokerage fee to purchase Treasurys at auction). For smaller amounts, the percentage of your assets that you’ll pay for a bond fund’s fees won’t amount to very many dollars. The young 401(k) investor, for example, would do well to purchase a bond fund, or better yet, a low-fee target-date fund.
Second, if you have substantial taxable assets, then you might want to lower your tax burden by investing perhaps 30% to 40% of your fixed-income portfolio in a short-term or intermediate-term municipal-bond fund, preferably with an expense ratio of 0.20% or less.
For most folks, the biggest threat to their retirement nest egg is that they’ll abandon their chosen strategy when the going gets tough; if your portfolio lets you sleep at night, you’re more likely to succeed. And in tough times there’s no better sleeping potion than the bonds issued or guaranteed by Uncle Sam.