Bond Diversification

[ArmchairMillionaire23]

This is my first post (other than the 'Hi...' one) so bear with me a little.
As you can tell by my username I am a big fan of Lewis and Schiff's "The Armchair Millionaire" and have used their investment strategy pretty consistently for most of the last 20 years or so. In a nutshell, they proposed being 100% invested in the stock market and splitting your investments into:

1/3 Large Cap US index funds
1/3 Small Cap US index funds
1/3 International index funds

From my early 20s up to my late 40s this allocation worked well for me. As I get closer to retirement I realize that I should include some bond funds in the mix in order to be more diversified. A couple of years ago I switched to a 75% stock, 25% bond mix by switching to the following:

25% Large Cap US index funds
25% Small Cap US index funds
25% International index funds
25% Total Bond Market index funds

Now that I've set a tentative early retirement date (Jan 1st, 2025) and it's less than 5 years away, at the beginning of this year I switched to a more conservative 60/40 stock/bond mix by changing my allocations to:

20% Large Cap US index funds
20% Small Cap US index funds
20% International index funds
40% Total Bond Market index funds

Going back to The Armchair Millionaire portfolio, their reasoning behind their allocation was due to the correlation of the three classes of funds providing the highest overall level of returns. Rarely did all three classes perform poorly at the same time. (they likened it to owning shares in both a sunscreen company and an umbrella company - you could be making money whether the sun was shining or if it was raining) However The Armchair Millionaire made no mention of investing in bond funds.

So my question is - If I were looking to diversify my bond holdings, does anyone know of two low cost (index?) bond funds that have a negative correlation so I could split my 40% bond allocation into two groups of 20% to be more broadly diversified? Or should I just keep it to total bond market funds? (I have four different retirement accounts - previous employer 401-k, current 401-k, Roth IRA and a taxable account that could also be used for an emergency fund)

Thanks in advance for any suggestions.

[audreyh1]

Bonds diversify against stocks.

Personally with fixed income I have cash, short-term bond index fund and regular bond index fund which tends to be intermediate duration. So I have some diversification across a range of durations. But that is actually motivated by the potential need to draw on fixed income for a few years, so it’s more like a ladder concept. But I do rebalance between the different funds as warranted.

[ArmchairMillionaire23]

Quote:

Originally Posted by audreyh1 Bonds diversify against stocks. Personally with fixed income I have cash, short-term bond index fund and regular bond index fund which tends to be intermediate duration. So I have some diversification across a range of durations. But that is actually motivated by the potential need to draw on fixed income for a few years, so it’s more like a ladder concept. But I do rebalance between the different funds as warranted.

Thanks for the insight!
I don't plan on using them for income for the next 5 years but that's a good thought about the range of durations as a diversification factor.

[Dtail]

In general, it appears that under bear market situations, the Treasury type bond funds appear to have less correlation to stocks.
If looking just for diversification, yes like @Audrey stated.
Perhaps you wish to also look for special CD deals when they appear.

[ArmchairMillionaire23]

Quote:

Originally Posted by Dtail In general, it appears that under bear market situations, the Treasury type bond funds appear to have less correlation to stocks. If looking just for diversification, yes like @Audrey stated. Perhaps you wish to also look for special CD deals when they appear.

I've been thinking about 'CD deals" for some of my money in the bank and my emergency funds but I have a couple of home improvement projects to do this summer so I didn't want to tie up too much cash right now.

[Freedom56]

Quote:

Originally Posted by ArmchairMillionaire23 This is my first post (other than the So my question is - If I were looking to diversify my bond holdings, does anyone know of two low cost (index?) bond funds that have a negative correlation so I could split my 40% bond allocation into two groups of 20% to be more broadly diversified? Or should I just keep it to total bond market funds? (I have four different retirement accounts - previous employer 401-k, current 401-k, Roth IRA and a taxable account that could also be used for an emergency fund) Thanks in advance for any suggestions.

I would avoid bond funds. The diversified one's are holding so called "investment grade debt" that are going to zero. Passive bond funds/ETFs are very dangerous to own now. They offer very little yield versus the risk to hold them. You are better off buying CDs than taking a risk with passive bond funds/ETFs.

If you want exposure to bonds, you need to be very selective and ignore the bond ratings and look at metrics like credit default swap implied ratings (what it costs to insure bonds from default) and income statements and balance sheets. For example Macy's bonds have a BBB- rating (low investment grade) and a company like Netflix has a BB- (mid junk rating).
I'm willing to bet that Netflix survives longer than Macy's and Netflix bond holders will get full redemption price of their short/medium term notes. I can't say the same for Macy's bond holders. The bond market agrees with me as the BB- rated Netflix 2025 notes sell above par (even after the sell-off) with a YTM of 4.7%

Bonds Detail

Macy's BBB- rated 2023 notes trade at a YTM of 15.14% after this recovery.

Bonds Detail

Macy's was only recently downgraded to BBB- which also tells you how poor that bond ratings are an indicator of quality.

So what does this mean for passive bond fund holders? You need to select bond funds that are sector specific such as technology, healthcare, pharma, or biotech. What we will start to see soon are massive defaults in the energy, retail, and commercial real estate sectors. You really should avoid those sectors or funds that invest in those sectors.

What I do is avoid funds altogether and build my own portfolio of short and medium term corporate bonds/notes and FDIC insured CDs with a combination of high yield and investment grade notes that I hand pick based on their overall financial health and business model. This eliminates the market risk associated with owning bond funds. I only add bonds/notes to my portfolio when they are undervalued relative to CDs and treasuries.

[pb4uski]

Quote:

Originally Posted by ArmchairMillionaire23 I've been thinking about 'CD deals" for some of my money in the bank and my emergency funds but I have a couple of home improvement projects to do this summer so I didn't want to tie up too much cash right now.

I have been using CD specials instead of bond funds. No credit risk. No interest rate risk. I have CDs with 3 different credit unions. Weighted average APY of 3.29% for 5-year CDs and 2.25% for 17-month CDs.

But I'm skeptical that we'll see such great APYs anytime soon after the Navy Federal CU 2.25% 17-month and 3.0% 5-year specials expire.

I've gone a bit overboard... now ~47% of total nestegg.

[audreyh1]

I like high quality bond mutual funds and don’t consider them dangerous to own. I don’t buy non-US treasury bonds individually, and I don’t buy directly from the US treasury very often either.

I buy CDs with new funds when the yields are favorable to treasuries and bond funds and the terms aren’t that long. I tend to just use the shorter term CDs.

[ArmchairMillionaire23]

I've never bought individual stocks or bonds. I've always utilized index funds. My taxable account, previous employer 401(k) and Roth IRA are through Vanguard and I am invested in basically similar funds in each of the accounts. (The 401-k offers institutional funds while in the IRA and taxable accounts I utilize Admiral share index funds. My current employer 401-k is through John Hancock and I try to find similar funds - some of them are actually Vanguard funds, albeit at a higher expense ratio that I get directly from Vanguard)
Thanks to everybody for the responses so far. I now have more options to consider.