Goosing Bond Allocation - Thoughts?

[madsquopper]

Close to retiring and am thinking about simplifying things a bit and consolidate holdings. General asset allocation is and will stay around 60/40 (equities/bonds) plus or minus a few points. For the 40% bond part I'm considering something like:

50% BND (US bond index)
25% BNDX (International bond index)
25% GHYG (Global high yield, about 60% is US)

Thoughts? Perhaps having 25% of bonds in high yield is a bit much, perhaps go a bit lower. As is, might be more like having an overall 65/35 split.

Larry

 

[Quantum Sufficit]

You want bonds to diversify your equity holdings. Take your risk on the equity side. Buy high quality short- to medium duration bonds. I am staying away from international bonds as I do not believe they will represent much in the way of benefit long term for my portfolio.

 

[Gearhead Jim]

Bonds and Bond Funds are very different animals.

If you go through all the difficulties of buying individual bonds, you can only lose money if there are defaults, or you sell early into rising interest rates. You always come out ahead, minus inflation.

With a Bond Fund, rises in rates give you an immediate loss in the fund. Sure, the higher rates will someday give you increased interest. But if rates keep rising for years, or even for decades, then you have to wait a very long time to break even.

To me, bonds exist to reduce volatility in my AA, especially now that I am retired. Bond Funds don't do that job for me. I've gone to mostly CD's and cash, I find individual bonds to be too complicated. Again, I might make more money in a bond fund, but I might not. That's what equities are for.

Others will disagree, and I'm listening...

 

[Jmo1969]

Gear head jim is on point. The bond market is somewhat broken, still. I'd keep the maturities very short if you have to buy bonds or buy floating rate bonds.

 

[pb4uski]

My targets for the 40% fixed income are 6% cash and cash equivalents (~ 18-24 months of spending), 22% investment grade corporates, 5% high yield and 7% interntaional.

I have been using the Guggenheim Bulletshares for some of my fixed income. they are a target date bond fund and the fund terminates and distributes cash at the end of the year that the bonds mature.

I would be hesitant to double my high yield position to 10% as you plan to.

 

[photoguy]

If you go through all the difficulties of buying individual bonds, you can only lose money if there are defaults, or you sell early into rising interest rates. You always come out ahead, minus inflation.

With a Bond Fund, rises in rates give you an immediate loss in the fund. Sure, the higher rates will someday give you increased interest. But if rates keep rising for years, or even for decades, then you have to wait a very long time to break even.

Is there any practical difference between these two options? Isn't the bond fund basically just a mark-to-market version of the bond? With a rise in interest rates, you can't sell the bond before it matures without losing principle (ignoring inflation) and similarly with the bond fund you won't recover your principle until the higher yield catches up over time.

 

[Which Roger]

I don't agree with the "hold a bond to maturity and you don't lose anything line of thought". It's technically correct, but if you hold a bond to maturity, and rates go up, there is the opportunity cost of not being able to purchase a different bond that pays a higher interest rate.

 

[Gearhead Jim]

Is there any practical difference between these two options? Isn't the bond fund basically just a mark-to-market version of the bond? With a rise in interest rates, you can't sell the bond before it matures without losing principle (ignoring inflation) and similarly with the bond fund you won't recover your principle until the higher yield catches up over time.

With a bond ladder (or CD ladder, like we have now) we don't expect to ever sell before maturity. For those who might need the money before maturity, then there can be a problem. But a normal bond fund never reaches maturity, so you always have that problem (or that benefit, if rates are declining; not too likely in the near future)

I don't agree with the "hold a bond to maturity and you don't lose anything line of thought". It's technically correct, but if you hold a bond to maturity, and rates go up, there is the opportunity cost of not being able to purchase a different bond that pays a higher interest rate.

That's technically correct, but I think "making less profit" is a different animal from "losing money", with an asset that I own only to reduce portfolio volatility.

 

[modhatter]

That's technically correct, but I think "making less profit" is a different animal from "losing money", with an asset that I own only to reduce portfolio volatility.

Yes, that has been my thinking. For a person who has a large lump sum to invest in the market now - purchasing 40% bond funds at the interest rate environment we are in now seems destined to lose money in your bond fund. Buying short term bonds would have a lower yield than CD's and most likely lose value in the ensuing years. So how do you justify buying into bond funds now? I'd say the chances of interest rates dropping lower over the years is pretty unlikely. Who's going to throw $400,000 into bond funds now?

 

[Khufu]

I don't agree with the "hold a bond to maturity and you don't lose anything line of thought". It's technically correct, but if you hold a bond to maturity, and rates go up, there is the opportunity cost of not being able to purchase a different bond that pays a higher interest rate.

This is not correct, unless you can predict interest rates, which we assume you can't. In that case if interest rates rise, you never have the opportunity truly to get the higher yield because to do so you would have to sell your bond which has already declined in market value so that the yield from your original bond is competitive with the new, higher yielding bonds. That is to say, the re-investment of your interest received will be at the new, higher rates, more of less, whether you reinvest them in the same bond (if possible) or in a new bond.

 

[Khufu]

25% GHYG (Global high yield, about 60% is US)

Thoughts?

High yield bonds should be counted in the equity portion since they correlate with equities.

 

[pb4uski]

High yield bonds should be counted in the equity portion since they correlate with equities.

I understand your reasoning but have never heard of anyone including high yield bonds as part of their equity allocation. Not sure about GHYG but I know Vanguard includes my high yield bond funds in bonds in any asset allocation analysis. Ditto with M*, so I'm skeptical. Sorry.

 

[photoguy]

I thought it was pretty standard to apportion part of one's high yield allocation as equities.

 

[pb4uski]

Never heard of that.

I know that Vanguard's Portfolio Watch show my high yield bond funds as bonds and if I enter GHYG into M* Instant X-Ray it indicates that the asset allocation is 1% cash, 92% bonds and 7% other.

 

[HFWR]

Strictly speaking, hi-yield bonds are indeed bonds, but historically they tend to move in more correlation with equities. Or that's the thought process being discussed here. I have no actual reference for that.

 

[Which Roger]

Bonds are supposed to provide safety. There is nothing wrong with owning high-yield bonds, as long as the owner recognizes that they are adding risk and therefore takes on less risk with other assets.

A portfolio consisting of 60% stocks and 40% short/medium term bonds is more risky then a portfolio with 60% stocks, 30% short/medium bonds, and 10% high-yield bonds. But in the latter, changing the allocations to something like 58/32/10 (my guesstimate) might result in the same level of risk.

 

[pb4uski]

.....There is nothing wrong with owning high-yield bonds, as long as the owner recognizes that they are adding risk and therefore takes on less risk with other assets.

A portfolio consisting of 60% stocks and 40% short/medium term bonds is more risky then a portfolio with 60% stocks, 30% short/medium bonds, and 10% high-yield bonds. ....

This seems inconsistent. Did you mean less risky rather than more risky? If not, please elaborate as it would seem to me that substituting high yield bonds for short medium term bonds would make a portfolio more risky, not less risky.

 

[Khufu]

I understand your reasoning but have never heard of anyone including high yield bonds as part of their equity allocation. Not sure about GHYG but I know Vanguard includes my high yield bond funds in bonds in any asset allocation analysis. Ditto with M*, so I'm skeptical. Sorry.

If you are trying to diversify to reduce risk, which would be the usual reason for a portfolio divided between bonds and equities, which would be more important to you, the word "bond" or the correlation with bonds and equities?

 

[pb4uski]

I guess to me in comparing the 1,3,5 and 10 year growth of $10,000 of the Vanguard High-Yield Bond fund, Total Bond and Total Stock it seems that high-yield is sort of in between and not clearly correlated with investment grade bonds nor clearly correlated with equities. I think a reasonable argument could be made that they are a distinct asset class.

It does seem that in distressing times that high-yield are more correlated with equities than with bonds.

I did find this interesting item on bogleheads:

In All About Asset Allocation, Ferri states that, "Statistically, only about 25 percent of the default risk in high-yield corporate bonds can be attributed to the same factors affecting equity returns; however the results are not statistically significant. If you allocate 10 percent of your total portfolio to one of the B-BB rated bond funds listed at the end of the chapter, at most perhaps 2 percent of that could be considered equity related. ... That being said, very-low-quality bond funds (those with an average credit quality of CCC or less) do have a higher correlation with equity returns."

Given the above and the fact that Vanguard and M* both include them in bonds for AA analysis and that my high-yield holdings are more highly rated non-investment grade bonds I will continue to include them in bonds in my AA analysis.

I think you make an interesting case that they should be in equities, but are there any credible sources that actually include them in equities in AA analysis?

 

[photoguy]

Even better than seeking experts opinion, you can look at the data and decide for yourself.

 

[ERD50]

Even better than seeking experts opinion, you can look at the data and decide for yourself.

Yes, I have done that in the past.

I hold a hi-yield bond fund - and I have always counted it as 50% equity, 50% fixed in my AA. It roughly looks to be about half as volatile as equity, close enough for me.

It's nice to see that the Hi-Yield funds have outperformed the S&P 500 index, with about half the volatility. I know the party is probably over for Hi-Yield, but I'm having trouble defining an exit point, and what to move it to.

-ERD50

 

[pb4uski]

Even better than seeking experts opinion, you can look at the data and decide for yourself.

If you read my post, you should see that I did decide for myself after looking at data and expert opinion.

I suspect that if one looked at the long-run historical cash flows of a high-yield bond portfolio of B+ or better that the cash flows would be more bond-like, even after defaults. Interestingly though, the market values tend to be more volatile and seem to be between equities and bonds. Since my high yield are only about 5% of my total AA, I'm not about to lose sleep over whether they are included in bonds or equities.

 

[Which Roger]

This seems inconsistent. Did you mean less risky rather than more risky? If not, please elaborate as it would seem to me that substituting high yield bonds for short medium term bonds would make a portfolio more risky, not less risky.

Yes, I meant less risky. Good catch, and sorry about the typo.

 

[photoguy]

If you read my post, you should see that I did decide for myself after looking at data and expert opinion.

Yes you did. I missed that, sorry.

I suspect that if one looked at the long-run historical cash flows of a high-yield bond portfolio of B+ or better that the cash flows would be more bond-like, even after defaults.

Most of the vanguard fund that I plotted is B+ or better (about 20% have lower ratings). Of course the lower rated funds may have been responsible for a big chunk of the losses (I don't have any data on this to know for sure). However, Vanguard's investment grade fund (VFICX) had a 10% drop in the last recession -- not terrible (compared to equities) but maybe my opinion would be different if my portfolio was more bond heavy.