Asset allocation strategies are popular among many commission-based and fee-only advisors right now largely because they seem like common sense. Most people think the stock market is the riskier place to put their money, but that they expect to receive greater rewards from stocks. Conversely, the popular view of the bond market is that it’s the place for conservative investors to park money they can’t afford to lose. Bond buyers will willingly sacrifice growth potential in exchange for the relative stability and steady income that bonds typically promise. Not surprisingly, this conventional wisdom isn’t spot on. Bonds can lose money, and the long-term risk is about on par with excellent value oriented stocks. The real advantage from bonds is the cushion from short-term volatility. Bonds make sense as an investment if one wishes to have a steady income from capital; when one is not seeking long-term growth.
Recent bond activity shows why conventional wisdom about stocks, bonds, and asset allocation isn’t correct. Even as the stock market has risen to all-time record highs, bonds have suffered big price declines that have awakened many bond-fund investors to the reality that their bond investments can actually lose money. Add to that the near certainty of further rate increases in the future as the Federal Reserve contemplates an exit from its quantitative-easing bond purchases, and you can see why bonds investing does not make an excellent long-term growth vehicle.
Losses throughout the bond market in recent months have been substantial, and how much of that investors have suffered depends on exactly where they had their money. On the passive-index side, all-purpose bond ETF Vanguard Total Bond has declined by almost 4% since the end of April, even after you take into account the income that the ETF has paid. Actively managed bond ETF investors haven’t fared better, with the popular PIMCO Total Return ETF dropping 4.5% over the same time period.
But long-term bond investors have seen truly massive declines. The iShares Barclays 20+ Year Treasury ETF is off almost 14% since the beginning of May, as long-term rate movements have produced much larger capital losses in long-duration bonds. The sharp move has given bearish bond investors huge profit opportunities, as the leveraged inverse bond ETF ProShares UltraShort 20+ Year Treasury ETF has posted gains of more than 30% over the same period.
Even some bonds that many thought would be immune to interest rate movements have seen losses. iShares Barclays TIPS Bond, which buys inflation-adjusted bonds, has dropped almost 8% over the past few months. The reason has been that inflation isn’t driving rates higher, but rather the expectation of tighter monetary policy and better economic conditions.
So far, strong returns from stocks have generally offset bond declines in balanced portfolios. But what’s happened over the past few months should alert you to the potential for further capital losses from your bond holdings if the rising-rate trend continues, and further rate increases could come even if the stock market falters from its record-setting move.
This sort of movement doesn’t mean that you should walk away from bonds if you are seeking secure income. A good laddered bond strategy will be immune to these sort of fluctuations, so long as you aren’t trying to trade your bonds (i.e., all you want is the income). Of course, you have to use individual bonds to create a ladder. This is something Liberty Hill Investing, or other reputable fee-only advisors in the Bay Area, will do on a regular basis when creating income for clients. Using individual bonds rather than bond mutual funds and ETFs can help you avoid permanent losses, because if you hold the bonds to maturity, you’ll receive the full principal amount back regardless of bond-market swings along the way.
An even better alternative for many seeking a short term port for capital is to use CDs rather than traditional bonds. In many cases, CDs pay better rates than high-quality bonds even though CDs are guaranteed by the federal government. If rates rise, your CD won’t lose value, and you can even take money out early if you’re willing to pay what is often a modest penalty. Similarly, savings bonds tied to the rate of inflation don’t offer huge returns right now, but they do give you full principal protection and hold their purchasing power through automatic inflation adjustments over time.
The recent movement in the bond market has been a painful lesson for many bond fund investors. For money you need within the next few years, finding the right investment vehicle to avoid the volatility of the stock market is more important than ever. By being smart about which fixed-income investment to make, you can find the right balance between risk and return for your financial situation.