"Game Over" (for bonds) - Jonathan Clements

[kevink]

A typically excellent post from the well-known former WSJ finance writer:

https://humbledollar.com/2020/10/game-over/

As usual the comments on this piece are also worth a look; Clements draws a thoughtful crowd.

 

[gerntz]

It is easy to sell bonds when need cash.

 

[Time2]

A typically excellent post from the well-known former WSJ finance writer:

https://humbledollar.com/2020/10/game-over/

As usual the comments on this piece are also worth a look; Clements draws a thoughtful crowd.

I'm 65 and feel I missed the boat for Bonds. I got about 3% of NW in bonds several years ago and that's it. I plan on holding cash to cover a few years expenses.

 

[pb4uski]

Boy, that article makes me feel really good about gourging out on 3.0%-3.5% 4-5 year CDs in 2019 (40% of portfolio). I just hope that things normalize before they mature in 2023-2024.

 

[MichaelB]

Zero bound or negative interest rates means insurance rates will continue to rise...

Boy, that article makes me feel really good about gourging out on 3.0%-3.5% 4-5 year CDs in 2019 (40% of portfolio). I just hope that things normalize before they mature in 2023-2024.

Good luck with that. It’s probably worth your while to prepare a Plan B, just in case.

 

[audreyh1]

This is for people who are looking to fixed income to provide an income stream. Which is not our case.

Ballast still works. Even if very high quality bonds don't go up when stocks crater, they won't go down, which is the whole point.

I don't expect fixed income to protect the portfolio from inflation either. That's the role of equities. Non-corporate bonds are to diversify against equities.

 

[NW-Bound]

From the quoted article in the OP:

We can’t expect bonds to fulfill their traditional income-generating role—and I’m not sure the tradeoff is all that attractive if we buy them as a diversifier for stocks. That leaves us with role No. 3: Hold bonds as a backup source of cash if it’s a bad time to sell stocks.

If that’s our reason for owning bonds, we might still stick with government securities—but instead of plunking for the long-term Treasurys that’ll potentially deliver big upside gains when stocks next suffer, we might go for short-term bonds. That way, we’re taking very little interest rate or credit risk, and thus—if we need cash from our portfolio—we can be confident our bonds should be worth pretty much what we paid, no matter what’s going on in the world.

In other words, I’d stop thinking of bonds as a source of yield or as a diversifier for stocks. Instead, think of them as way to generate cash if the stock market is in the toilet.

A big portion of my fixed income AA is in a Black Rock T-Fund. Its yield varies, and used to pay 2% which would offset inflation, but is now only 0.01%/yr!

It is allowed to count as cash, for the purpose of covering put options. Hence, I have been writing deep out-of-the-money put options against that fund, in order to generate some income.

How much money have I got out of that activity? I know how much income I got from option premiums, but the total also includes the stock-covered call options. It will take me a bit of work to separate out the premiums from calls and from puts, but I would say the puts get me significantly more than the 2% yield from the "cash".

 

[jazz4cash]

Boy, that article makes me feel really good about gourging out on 3.0%-3.5% 4-5 year CDs in 2019 (40% of portfolio). I just hope that things normalize before they mature in 2023-2024.

Same here but I’m way less than 40%....and I disagree with the reply to a commenter that Munis are no better since they tanked at the beginning of the pandemic. Individual munis tanked briefly but those bargains were bought up and the prices rebounded. The whole topic is a bit confusing. I agree if you are buying bonds today they may not fulfill their traditional roles but if you have a portfolio consisting of bonds purchased at higher yields you should be good assuming you have emergency funds elsewhere.

 

[HawkOwl]

This is for people who are looking to fixed income to provide an income stream. Which is not our case.

Ballast still works. Even if very high quality bonds don't go up when stocks crater, they won't go down, which is the whole point.

I don't expect fixed income to protect the portfolio from inflation either. That's the role of equities. Non-corporate bonds are to diversify against equities.

There are TIPS and I-bonds.

Agree that ballast still works, and is my primary reason for owning fixed income.

 

[kevink]

A worthwhile "bookend" to the Clements piece is this recent John Reckenthaler column on the Morningstar site:

https://www.morningstar.com/articles/1003235/four-questions-about-bonds

His analysis is similar to Clements' but he does suggest a couple of additional options that may or may not be of interest.

For those like me who weren't smart enough to load up on 3-4% CDs like some of you folks it seems to me that good (or at least "less bad") options include online bank one year CDs in the .80% range (still better than 10 year Treasuries with far less interest rate risk), maxing out the 10K per person per year iBond purchase limit (1.06% coupon plus semi-annual inflation adjustment), and perhaps a chunk in a fund like Vanguard's VBIRX/BSV (2.9 year duration, 65% Treasuries and agencies, rest high-quality corporates).

Reckenthaler echos some of Ray Dalio's latest posts in at least thinking about going futher afield by adding a slice of gold or looking at alternative asset classes - neither of which are likely to be of much appeal to most who post here, I realize. At the end of the day I think Clement's approach is pretty realistic: own T Bills or the equivalent for dry powder and make sure you have enough of it to match your life situation and risk tolerance and put the rest in a diversified equity portfolio and let it ride.

 

[OldShooter]

Clements' last three paragraphs basically describe where we are. No economic need to sell equities for at least 5 years.

I'm not terribly worried about short-term inflation, but the bulk of our bond side is still in TIPS. That's much more reliable protection than hoping that equities will bail you out on a near-in basis. When you realize that TIPS interest payments adjust with inflation, the YTM is a little better than if you just do the naive calculation. But it's still not much.

 

[friar1610]

Boy, that article makes me feel really good about gourging out on 3.0%-3.5% 4-5 year CDs in 2019 (40% of portfolio). I just hope that things normalize before they mature in 2023-2024.

My stroke of genius was about 20 years ago when I bought some (but not enough) I-Bonds with a 3.4% fixed rate. Haven't done anything quite so smart on the fixed income side since then, although the NFCU certificate specials were nice while they lasted.

I don't envision doing much more than taking whatever the market offers safely going forward.

 

[NW-Bound]

A big portion of my fixed income AA is in a Black Rock T-Fund. Its yield varies, and used to pay 2% which would offset inflation, but is now only 0.01%/yr!

It is allowed to count as cash, for the purpose of covering put options. Hence, I have been writing deep out-of-the-money put options against that fund, in order to generate some income.

How much money have I got out of that activity? I know how much income I got from option premiums, but the total also includes the stock-covered call options. It will take me a bit of work to separate out the premiums from calls and from puts, but I would say the puts get me significantly more than the 2% yield from the "cash".

After making the above post, I decided to sit down to figure out for myself how much all that option selling made for me. It took a couple of hours.

Now, I use Quicken to download all financial transactions, and it can quickly tell me how much money I made from option trading. However, there's no way to separate out call and put option trading.

So, I had to download all account activities from my brokerage in a form of a CSV file, then imported it into OpenOffice to massage. It took me some time to fumble around, because I am not a spreadsheet wizard. I finally got the answer: roughly 1/3 of the gain from option trading comes from put options, while 2/3 comes from call options. This makes sense, as I still have more stock than cash.

Now, how do I compute the gain in terms of percentage? I now have the numerator, but what is the denominator? I know how much "cash" I hold in the T-Fund to backup the puts, but never use all of it. My trading activity varies with market condition. I think I have gone as high as 50+%, but it is usually around 25%.

But let's take the whole T-Fund balance as the denominator. Wow, my return on put options on that T-Fund balance is more than 15% YTD. It's better than I thought. In fact, in dollar amount, the put option premium is more than I spend in a year. Son of a gun!

But, but, but it's not that simple! About 90% of the puts expired worthless per my plan, but the other 10% ended up in-the-money, causing me to have to buy the stocks. Now, I rarely ever closed out an option, preferring to let it get exercised, because I only sell put options on stocks that I do not mind owning, and at a lower price than when I started the trade.

What then happened to those shares? Quite often, I lost a bit of money when the options got exercised and I had to buy the shares at a price above then market value and the option premium did not make up for it.

I turned around and sold call options on these new shares. Maybe not right away, but waiting a bit for the market to turn around. And I often make money on both selling these shares, in addition to booking another call premium. Still, right now, I am sitting on a bit of loss from some of these shares, but it's not that much.

So, you can see that accounting for all this is hard. What matters is the growth of the entire portfolio, and here I am doing OK, but not great.

To sum this up, my use of "cash" to cover put option selling is remunerative, and I will keep doing so.

 

[Koolau]

My stroke of genius was about 20 years ago when I bought some (but not enough) I-Bonds with a 3.4% fixed rate. Haven't done anything quite so smart on the fixed income side since then, although the NFCU certificate specials were nice while they lasted.

I don't envision doing much more than taking whatever the market offers safely going forward.

Heh, heh, I do not claim genius (stroke or otherwise) but I TOO bought I bonds "back in the day" when they actually paid interest - not just inflation! I kick myself for not buying even earlier and even more of these (once) amazing instruments. If I had to pick just ONE thing to hold, (and I could actually do it) I think I'd pick the highest interest rate I-bonds (what was that, years around 1998 or so??). Imagine fixed "real" (roughly) 5% income with virtually NO risk. Nothing to manage EXCEPT to sell them back after 30 years (and then pay the taxes.) It's an impossible dream, but it's MY kind of dream, so YMMV.

 

[ImThinkin2019]

kevink - just want to thank you for starting this thread. And thanks to all of the contributors. It is one of the most informative threads I have read here. (I'm sure there are other great ones I have missed.)

We do remember the higher inflation times when some retirees laddered CD's for income. Not practical at this moment in history.

For our income, we buy and hold some higher risk private placement debt and plan to live on a portion of the income stream from that. We LBOM so this is possible

Our mutual fund allocation is for the future - hopefully our heirs. We think we cannot predict what the equity return will be, so we don't want to depend on it. We have lived through decades where the equity return was flat, and think this is likely again....

Of course if we learn to trade options it might be possible to get better equity returns, especially when the market is flat. But we have not tried that and likely never will. Too cautious..

 

[audreyh1]

There are TIPS and I-bonds.

Agree that ballast still works, and is my primary reason for owning fixed income.

One reason I don’t worry about bonds is that I have owned the bulk of my fixed income for over 20 years. It has appreciated as interest rates dropped, it occasionally drops as interest rates rise. I rebalance, buying more when down or after a strong equity year. A year after bonds have been “clobbered”, and compared to stocks it’s a mild clobbering, they tend to recover strongly. Interest rates jump around so much and so unpredictability that rebalancing seems the best management tool.

I understand someone looking to buy into bonds today, it perhaps looks a little bleak as they are highly valued. But it doesn’t mean you should sell bonds you already own and buy IMO riskier also fully valued stocks. John Clements agrees that stocks are riskier.

We are simply in another extreme QE environment where the Fed funds rate is pushed to zero and the Fed is buying bonds to boost market liquidity, and as a result there has been asset inflation in both stocks and bonds as investors take advantage.

I just keep rebalancing.

 

[tdv2]

I too look at my bond holdings as the "safer" place for a good chunk of my assets....~30%. I don't count on the yield from these holdings to live on nor do I try to change my asset allocation to chase yield. The more information I process by observing the financial markets just reinforces what I already know......I have absolutely no idea what is going to happen in the next few years.

 

[rayvt]

It is allowed to count as cash, for the purpose of covering put options. Hence, I have been writing deep out-of-the-money put options against that fund, in order to generate some income.
...
I would say the puts get me significantly more than the 2% yield from the "cash".

The money you get from selling options isn't income, it is investment profits.

 

[VanWinkle]

This is for people who are looking to fixed income to provide an income stream. Which is not our case.

Ballast still works. Even if very high quality bonds don't go up when stocks crater, they won't go down, which is the whole point.

I don't expect fixed income to protect the portfolio from inflation either. That's the role of equities. Non-corporate bonds are to diversify against equities.

+1, It is not different this time!!

 

[Markola]

I can’t argue with the picture Clements paints but a few reactions to it:

1) The article is 100% domestic U.S. focused. Those of us who believe in global diversification might benefit from different dynamics in the rest of the world in coming years, such as a falling dollar and faster population/economic growth elsewhere.

I assume Vanguard is smarter than me and note that their target date funds have 40% of their equity allocations and 25% of their fixed income allocations to international.

2) Those who lived through the 70s and 80s tend to naturally mitigate against future inflation but the current super-low interest rate and inflation environment and Covid recession may well mean that deflation is the bigger risk. If so, I’m glad to own bond funds and am not ready to pile into more stocks to chase yield.

3) People here tend to not view their home as part of their net worth statement but I do. We are experiencing inflation in home prices and, over time, our very low interest mortgage leverage will hopefully allow significant equity accumulation. That and aging will eventually cause us to not want a SFH to maintain, so I expect a cash infusion many years out, probably around age 70 when we accept maximum SS.

I don’t know nuthin’ but I am hopeful that diversification can mitigate bond yield issues.

 

[Midpack]

There have been countless articles since 2008 “warning” about bonds. Eventually I’m sure they’ll come true, but we’ve gotten decent returns in the “ballast” portion of our AA holding on all this time. Glad we didn’t listen in 2008. Was there a better place to hold low risk non-equity assets over the past 12 years? Is there now (equivalent risk)?

 

[audreyh1]

2) Those who lived through the 70s and 80s tend to naturally mitigate against future inflation but the current super-low interest rate and inflation environment and Covid recession may well mean that deflation is the bigger risk. If so, I’m glad to own bond funds and am not ready to pile into more stocks to chase yield.

Agreed - economic weakness seems more likely regardless of the current close to all time highs equity market. And you don’t want chase yields in fixed income either by going for lower credit quality like junk or even mostly corporate bonds. Those are very economically sensitive.

Pretty much rock and a hard place conditions right now.

 

[OldShooter]

Agreed - economic weakness seems more likely regardless of the current close to all time highs equity market. And you don’t want chase yields in fixed income either by going for lower credit quality like junk or even mostly corporate bonds. Those are very economically sensitive. Pretty much rock and a hard place conditions right now.

Yup.

John Bogle: "Don't just do something. Sit there."

Warren Buffet: "Much success can be attributed to inactivity. Most investors cannot resist the temptation to constantly buy and sell. ... Lethargy bordering on sloth should remain the cornerstone of an investment style."

zzz ...

 

[kevink]

To your point Markola: Clements has about 67% of his portfolio invested in a fully internationally diversified (i.e. ~55% US/45% Int'l), small-cap and value-tilted equity portfolio and is comfortable with at least that much in equities in retirement.

And to OldShooter's comment about TIPS being the best inflation protection, here's Wade Pfau's concise summary of William Bernstein's analysis of that topic in his essential (IMHO) recent booklet "Deep Risk:"

"First in terms of the probabilities that each threat will manifest, inflation is high, confiscation is medium, and deflation and devastation are low. Inflation, though high in probability, has a lower cost for protection. It is the most relevant for retirees to worry about, but it is also the least catastrophic for a globally diversified investor. It is the easiest to protect against with international [equity] diversification, TIPS held to maturity to match spending needs, delaying Social Security, and an inflation-adjusted annuity. A globally diversified stock portfolio is most effectively protected from the deep risk of inflation, though stocks do exacerbate shallow risk. Meanwhile, unexpected inflation devastates traditional bonds."

My take is that globally-diversified equities are the most important inflation hedge. Cash in the form of Tbills has also historically been a surprisingly good hedge. iBonds up to one's annual limit are a no-brainer but won't help much in a larger portfolio in less one got started long ago (or has decades until retirement).

As for TIPS, who knows? If one was wise enough to buy them back when their coupons offered a positive return sure, but now? Personally I'd rather have more international equity exposure and a slice of gold for SHTF and further currency debasement (aka "quantitative easing") antics from the Fed. YMMV. A couple of articles back Clements said he was keeping all his "cash" in a barbell of equal parts short TIPS and short-term Treasuries.

 

[Abe Frohman]

I remember 5 to 10 years ago, I don’t remember when it was. My dad lamenting the fact that his 12% 30 year treasury bond paid off.