Why do we do this?

[OldShooter]

I have been thinking a little more about the fixed income side of portfolios lately because I've been helping a nonprofit select a manager and invest about $4M. One question I've been turning over in my mind is this:

Pretty much all of us start with some kind of asset allocation. 50/50, 60/40, or whatever and put a bunch of money into the "safe" side: Fixed income. Then I think almost all of us start looking for ways to increase yield over the really safe options like high-grade corporates, govvies, and agencies. Inevitably these higher-yielding choices involve increased risk and increased volatility. TANSTAAFL, after all.

Why do we do this? Why don't we just allocate a small additional amount to equities, adding roughly the same amount risk and volatility to the portfolio, then relax and just buy nice safe govvies and agencies for the "safe side?" Risk correlation might be the reason, but I don't think the equity risk and the risk of, say, junk bonds is uncorrelated. If things get exciting, both are going to move southward.

What say you?

 

[Huston55]

I don’t know.

But, I do know that when I visit my broker’s office to discuss where I can find an extra 0.0X% return from my fixed income allocation, I drive around the parking lot for 10 minutes to get a parking place that’s 20 steps closer to the front door, then I insist on taking the extra time at their free coffee machine to make a Latte instead of settling for just plain coffee. On the way out, I also search through the candy bowl to pick out only my favorites.

 

[pb4uski]

I guess it depends on what kinds of risk you are willing to accept in exchange for a higher return. On the fixed income side I have targets for high-yield and emerging market bonds within my fixed income allocation to just spice things up a little bit... about 16% and 3% of my fixed income, respectively.... the remainder is in more benign corporates and international bonds.

The non-profits that I am involved with would probably not have much interest in equities.... though perhaps they should because in both cases they have a fair amount of money that isn't working very hard for them but the political and perceptual implications of investing in equities are pretty overwhelming.

 

[OldShooter]

I guess it depends on what kinds of risk you are willing to accept in exchange for a higher return. On the fixed income side I have targets for high-yield and emerging market bonds within my fixed income allocation to just spice things up a little bit... about 16% and 3% of my fixed income, respectively.... the remainder is in more benign corporates and international bonds.

Yeah. Lots of that going around. We are in TIPS, T-bills, and floating rate funds (SAMBX). But my question is still: Why? Is there something fundamentally more conservative about adding risk on the fixed income side vs adding it on the equity side? I can't see that there is, but apparently something deep in my llizard-level brain does think so.

The non-profits that I am involved with would probably not have much interest in equities.... though perhaps they should because in both cases they have a fair amount of money that isn't working very hard for them but the political and perceptual implications of investing in equities are pretty overwhelming.

Different situation for us. There will be a long-range bucket of maybe $3M around 80% in equities. But my question is really unrelated to the nonprofit. Working with them has just stirred my thinking up a little bit more than usual.

 

[zesty]

This is what Larry Swedroe has always suggested, just take your risk on the equity side. I think he only recommends T-bills and TIPS.

 

[bloom2708]

I've been told to "take your risk on the stock side of your portfolio".

Do that by increasing or decreasing the percentage of stocks.

On the bond side, stick with short to intermediate high quality funds taking tax placement into consideration. Keep some cash or CDs in the safe side.

It sounds simple, but in practice it is hard. People just love chasing a little more interest or return.

 

[pb4uski]

Yeah. Lots of that going around. We are in TIPS, T-bills, and floating rate funds (SAMBX). But my question is still: Why? Is there something fundamentally more conservative about adding risk on the fixed income side vs adding it on the equity side? I can't see that there is, but apparently something deep in my llizard-level brain does think so. ....

I pretty much agree... my international and emerging market bond investments are for entertainment as much as anything... I could easily do without them and if I was on my deathbed I would sell them and simplify for DW and DD. Similar thought with high-yield but I'd probably still have some but scale back to 5-10% of total fixed income rather than eliminate them entirely.

I'm actually not a big fan of government bonds.... I still think they are more return-free risk rather than risk-free return at these low interest rate levels... I prefer low duration high-grade corporates instead.

 

[VanWinkle]

I pretty much agree... my international and emerging market bond investments are for entertainment as much as anything... I could easily do without them and if I was on my deathbed I would sell them and simplify for DW and DD. Similar thought with high-yield but I'd probably still have some but scale back to 5-10% of total fixed income rather than eliminate them entirely.

I'm actually not a big fan of government bonds.... I still think they are more return-free risk rather than risk-free return at these low interest rate levels... I prefer low duration high-grade corporates instead.

Agree with this thinking also, I am about half intermediate corporate bonds and half intermediate Government bonds. I take all of my risk on the Equity side.

 

[Car-Guy]

My POV, from the folks I know pretty well, it's usually either driven by greed or by people who depend on the higher returns to fund their retirements the way they want. Sometimes both I think.

 

[Ologist]

I used to buy bond funds, but because of rising interest rates was advised to buy individual bonds. Intermediate term individual bonds held to maturity, therefore not losing any money.
Individual bond portfolios cost money. Bombarded by fees. So what is the answer, pay the fees with individual bonds or go back to low cost bond mutual funds?
Thanks for your input!

 

[pb4uski]

Read this thread from the beginning and you'll see a couple options.

 

[USGrant1962]

they are more return-free risk rather than risk-free return at these low interest rate levels... I prefer low duration high-grade corporates instead.

Nice summary of the characteristics of government bonds. While there is low risk of default, you are still exposed to interest rate and inflation risks with little compensation.

As I've dug into my AA I realized that the "Bond Fund" in my 401(k) is 1/3 Treasuries, 1/3 investment grade corporate, and 1/3 asset backed (mortgages). It has a 0.25% expense ratio, which isn't bad for an actively managed bond fund, and a duration under 6 years. Seems like a reasonable solution to me and it has become the bulk of my fixed income allocation. So I get more yield than straight treasuries to help make up for interest rate and inflation risk.

 

[Doc0]

Your observation is very astute.

The 2 asset class portfolio (Stocks:Bonds) has a virtually linear efficient frontier so changing AA just moves you up and down the line. By introducing better diversity like adding GLD and TIPS you reduce the volatility for the same or better portfolio return

Here is a calculator to play with diversity and the efficient frontier

https://www.portfoliovisualizer.com/efficient-frontier

under the "gear" icon are several standard internet portfolios and in the drop downs are a variety of asset classes. You can compare 2 portfolios of different asset classes by choosing the dual efficient frontier option and checking the assets you want included in the portfolio. The program will optimize assets for best risk reward compared to a 1 mo T-Bill this is called the tangent portfolio.

Suggestion plug in US stocks Long term bonds gld and tips into the assets 25:25:25:25 and choose double frontier use the checks to choose all 4 in #1 and then US stocks and bonds in 2. This is called modern portfolio theory which won the nobel for Harry Markowitcz. The 4 asset optimized portfolio yields 7.61%/6.90% return volatility and the 40/60 optimized 2 asset portfolio yields 7.35% v 7.30%. So the more diversified portfolio yields better return with less vol.

 

[DrRoy]

I think it is partly because for most of our lives we have been able to do better on the fixed income side than the last 9 years, and we still have that expectation.

 

[audreyh1]

I have been thinking a little more about the fixed income side of portfolios lately because I've been helping a nonprofit select a manager and invest about $4M. One question I've been turning over in my mind is this:

Pretty much all of us start with some kind of asset allocation. 50/50, 60/40, or whatever and put a bunch of money into the "safe" side: Fixed income. Then I think almost all of us start looking for ways to increase yield over the really safe options like high-grade corporates, govvies, and agencies. Inevitably these higher-yielding choices involve increased risk and increased volatility. TANSTAAFL, after all.

Why do we do this? Why don't we just allocate a small additional amount to equities, adding roughly the same amount risk and volatility to the portfolio, then relax and just buy nice safe govvies and agencies for the "safe side?" Risk correlation might be the reason, but I don't think the equity risk and the risk of, say, junk bonds is uncorrelated. If things get exciting, both are going to move southward.

What say you?

Great question! I see people do this all the time - over time fixed income drifts towards higher yielding riskier assets, eschewing the higher quality bonds that don't yield as much.

It took only 2000-2002 which ended with a corporate credit crunch for me to see how very badly high yield funds, floating-rate bank loan funds can be hurt in such an environment - hey they drop just like equities! And that corporate spreads can widen suddenly such that even better quality corporate bonds may be hurt in such an environment (really saw that in 2008/2009).

I deliberately stick with a higher quality bond tilt in the fixed income portion of my AA and avoid high yield. I figure - if you want high yield - might as well own stocks instead!

I think folks sometimes try to get every asset class to outperform so they drift to the higher risk subsets, or they decide to reduce/avoid some assets classes some years for fear of near-term underperformance, forgetting that the whole point of an AA is that asset classes work as a whole together to reduce risk (reducing volatility at slight reduction in return) and that over time rebalancing takes advantage of some asset classes underperforming others.

I'm glad you brought this up!

 

[Senator]

Good question. I do not do what most others do. I have all of my investments in Stock and Real Estate, less a small amount for cash emergencies. I also have a HELOC I can use in an emergency.

For day-to-day cash flow, I have rental income. It covers all I need, and then some. It also keeps me with things to do.

I invested in my own "High grade mortgage bonds", at 5%+, which was initially used for my own rental properties. Since 2012, I have 'invested' or paid off almost $600K in mortgages and real estate acquisitions. That has increased my cash flow by about $7K a year.

I have a nice dividend stream from index ETFs that I can tap, from HDV, DVY, IVV, IVW, IWM, QQQ. I invest in dividends ETFs instead of any Bond allocation. Unless the market crashes for a VERY long time, I should be able to survive.

 

[audreyh1]

This is what Larry Swedroe has always suggested, just take your risk on the equity side. I think he only recommends T-bills and TIPS.

I've been told to "take your risk on the stock side of your portfolio".

Do that by increasing or decreasing the percentage of stocks.

On the bond side, stick with short to intermediate high quality funds taking tax placement into consideration. Keep some cash or CDs in the safe side.

It sounds simple, but in practice it is hard. People just love chasing a little more interest or return.

Totally agree, although I don't go Swedroe's route with only TIPs and US Treasuries/T-bills.

I own some diversified "core" intermediate bond funds, but I also own some govt-backed categories to push the overall credit quality more to the AA/A side. Plus I hold cash/CDs/iBonds and a very high quality short-term bond fund. No junk bond funds.

 

[audreyh1]

I used to buy bond funds, but because of rising interest rates was advised to buy individual bonds. Intermediate term individual bonds held to maturity, therefore not losing any money.
Individual bond portfolios cost money. Bombarded by fees. So what is the answer, pay the fees with individual bonds or go back to low cost bond mutual funds?
Thanks for your input!

IMO low cost high quality bond funds. If you are holding bonds indefinitely as part of an AA, as opposed to having some other use of your funds once the bond matures, you don't gain anything by "hold to maturity" anyway.

 

[audreyh1]

Nice summary of the characteristics of government bonds. While there is low risk of default, you are still exposed to interest rate and inflation risks with little compensation.

As I've dug into my AA I realized that the "Bond Fund" in my 401(k) is 1/3 Treasuries, 1/3 investment grade corporate, and 1/3 asset backed (mortgages). It has a 0.25% expense ratio, which isn't bad for an actively managed bond fund, and a duration under 6 years. Seems like a reasonable solution to me and it has become the bulk of my fixed income allocation. So I get more yield than straight treasuries to help make up for interest rate and inflation risk.

The compensation comes when the world goes to hell and the government bond funds appreciate while everything else is bashed. So you have an asset class you can rebalance from - sell to buy the beaten down other asset classes.

It's been a while since we've seen such a "rush to quality", but it really happens, and can be very dramatic.

I agree that your diversified core type bond fund looks like a good solution and is what I use at the heart of my fixed income AA.

 

[LRDave]

I consider TIAA Traditional to be very bond-like and count it on that side of the fence allocation-wise. Mistake? Disagree?

 

[UnrealizedPotential]

My guess would be that most of us have a fixed amount we wouldn't want to lose no matter what. That goes in fixed income, to get lower volatility and a little income. Then some is put in stocks for inflation and growth. Let's say 40% stocks and 40% fixed income. That still leaves 20% not invested.

The lure of extra income is great and hard to resist. Most fall prey to some extent. This is where the extra risk in high yielding bonds and other high yielding instruments come in. It's hard to resist going for the extra yield and it's easy to do it. Of course, the high yielders often act more like stocks than bonds in the up and downs of everyday trading.

Some of that extra cash could be held as cash, but I am guessing most people feel the need to do something with their money.

 

[VanWinkle]

My guess would be that most of us have a fixed amount we wouldn't want to lose no matter what. That goes in fixed income, to get lower volatility and a little income. Then some is put in stocks for inflation and growth. Let's say 40% stocks and 40% fixed income. That still leaves 20% not invested.

The lure of extra income is great and hard to resist. Most fall prey to some extent. This is where the extra risk in high yielding bonds and other high yielding instruments come in. It's hard to resist going for the extra yield and it's easy to do it. Of course, the high yielders often act more like stocks than bonds in the up and downs of everyday trading.

Some of that extra cash could be held as cash, but I am guessing most people feel the need to do something with their money.

As Bogle would say, Don't just do something, stand there!