Do you know why you own bonds?

Do you know why you own bonds in your portfolio? There are many reasons to own bonds but one of the biggest reasons historically is no longer a good one for many investors. Bonds are often held in portfolios to provide a safe and steady source of income, in particular for retired investors. But the long bull market in bonds is at best in its final innings and thus they no longer meet the goal of providing a safe and steady source of income. Lets take a look at some data and see what it tells us about bonds today.

The first chart I picked up the other day from Abnormal Returns and shows one measure of how much bonds may be over valued today.

Stock vs Bond Yields Dec 8 2012

The average dividend stock now yields a good deal more than AA rated US corporate bonds. And you get dividend growth to boot. But hey stocks are risky so most conservative investors wouldn’t put much salt in this chart I think. What if we could project what the 10 year forward returns for bonds will be? Well, it turns out you can. The current yield is the best indicator for 10 yr forward returns. Take a look at the chart below from O’Shaughnessy Asset Management. Read the whole analysis when you get the time.

OSAM 10yr fwd returns for US Int Bonds Dec 8 2012

Read the callout carefully. If bonds follow historical precedent they will return 0.59% per year through December 2021! Since these are nominal returns we then need to back out inflation and since bonds are taxed as ordinary income we need to take out taxes as well. Returns are so small you can pretty much ignore taxes but inflation will take bond returns negative to about -2.44% per year through 2021. If past is precedent investors will loose money in intermediate gov’t bonds over the next 10 years. So much for a safe and steady source of income. You might say fine, I’ll just go out the yield curve or take some credit risk by investing in long term treasuries or corporate bonds. The OSAM findings hold for those bonds as well. Yes, you will earn more than intermediate bonds but current yields are still the best predictor of forward returns. With both long term treasuries and corporates yielding less than 3% and inflation probably staying in the historical 3% range you are looking at zero real returns.

If you hold bonds in a mutual fund, ETF, CEF, or even individual bond issues one of the ways you have seen the effect I’m describing is lowered distributions from these funds. Look at the payouts of most bonds funds and you see income from the funds going down over the last several years. This is because as old bonds mature the new money is re-invested at lower yields and thus over time the distributions from these funds come down. Over the past several years this income reduction has been more than offset by capital appreciation from falling yields but as the OSAM study shows this is probably coming to an end. Again, so much for safe and steady income.

Maybe this time is different. The only situation that would make the above not happen is a new deflationary type scenario ala Japan. In that case yields will continue to fall and capital appreciation in bonds will make up for falling yields and since most other asset classes will fall as well, bonds will be the best house in a bad neighborhood. What would a Japan yield scenario be like? Below is a chart of Japanese 10yr government bonds yields back to Jan 2000.

Japan 10yr historical bond yield Dec 8 2012

Lets say we’re headed for a Japan scenario and US ten year yields will head to 0.5%, as low as they’ve been in Japan, in the next 5 years. With the US 10 year current at about 1.58% what would be the total return to these bonds if yields fall to 0.5%. It’s probably not as high as you think. The total return of from such a scenario would be about 12%. That’s it. That’s the thing with low current yields. The bang for the buck from lower yields is not as great. 12% over 5 years in a deflationary scenario is not bad, maybe it even happens over fewer years, but its not the bond bull market of the past especially after taxes and inflation. I don’t think the odds of this scenario are very high and even if I did the upside from this scenario is not great.

I do think bonds still have a place in a portfolio but for different reasons. To me they are great diversifies and a great place to stash cash while you wait for better opportunities in riskier assets like stocks. Bonds also have an important place in portfolios such as the IVY and Permanent portfolios as diversifiers where automatic rebalancing will have you adding money as bonds become a better value. Even better timing the IVY or the Permanent portfolios will get you out of bonds when they start a new down trend. For example, in the IVY timing model, a drop of about 3% in the IEF bonds ETF would have you out of bonds all together.

In summary, bonds are priced at the point where they no longer offer safe and steady income especially after considering inflation and taxes. While bonds are still important portfolio diversifiers there are better alternatives for many investors. The best alternative to bonds is a conservative dividend portfolio. As the first chart above showed many dividend paying stocks pay more than bonds and offer increasing income as well. The two most conservative and stable dividend sectors for investors to consider are utilities and consumer staples. While not my favorites for total return as bond replacements or enhancers they make a lot of sense in today’s environment. I’ll have more to say on utilities and consumer staples as alternatives to bonds in a future post.

Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.

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14 Responses to Do you know why you own bonds?

  1. Del Clark says:

    Good article, as usual. Would you suggest an exit strategy for current bond holders that would be triggered by a sell signal in the IVY portfolio for the bond component, IEF?

    • libertatemamo says:

      Hi Del, that’s a tough one. it depends a lot on what typed of bonds you hold, why you hold them etc.. But simply if the majority of your bond investments are in intermediate bonds then you could exit them whenever the sell signal for IEF triggers. If you have long term bonds then you can use TLT, for munis, MUB, etc…


      • Del Clark says:

        Thanks Paul. My bond investment is MWTIX which is designated as an intermediate term. MWTIX has a Morningstar rating of 5 and is up 11% this year.

        • libertatemamo says:

          Its a good fund. If its part of your long term investment allocation then I wouldn’t touch it. Just don’t expect the returns of the last few years going forward.


  2. donzidoug says:

    Thank you Paul. Great info as always. Do you think floating rate funds and senior loan funds can work well long term to replace part of an investors fixed income bond allocation? I have been using senior loan and floating rate cefs and oefs for a little over a year and really have enjoyed the unusually high yield and capital appreciation these have offered.

    • libertatemamo says:

      Doug, yes senior loan or floating rates funds are good for a rising interest rate environment especially. They don’t get as much bang for the buck with falling rates due to the short duration but that’s OK. The funds I like are BKLN and FFRHX. The senior loan CEFs are a bit tricky because of the leverage employed. The are highly sensitive to a credit event, just look back at their 2008 performance, and in a fast rising rate environment with short term yields rising faster than long term ones, the use of the leverage, can hurt as well. Due to this they are almost as volatile as stocks. The two I follow and have invested in the past are JFR and VVR but for that kind of volatility I’d rather own an MLP for higher yield. In this space I’d rather stick with BKLN or the Fidelity fund. I’m not trying to knock it out of the part with bonds, I just want a decent place to hold money until the next stock investment comes along. If I do want to hold longer term, munis still seem like the better deal at today’s prices.


      • donzidoug says:

        Thanks. On the subject of cefs…There’s a handful of guys over at the Morningstar forum. I think of them as silver backs because after following them for awhile its obvious these guys are seniors with financial backgrounds like you and know the ins and out of fixed income. One of the specialties that go on there is working the premium discount of fixed income cefs. Its a very slow moving target and I have to share that while learning about it I’ve also piggy backed on a few of those trades and we are taking 15% gains without doing anymore then including small batches of them in the mix. The best ones that come to mind right now are PDI, PFL, and PFN. I’ll be the first to admit that I do not understand these instruments fully but I am learning and to hear these old dogs chatter back and forth they have been using cefs for a long time as income and cap gains trades.

        • libertatemamo says:

          Yeah, the premium/discount CEF trade is not a bad one. CEF pricing is one of the areas of market inefficiency. I used to do a bit of that but find more bang for the buck position trading stocks.


  3. Jim says:

    I’d like to add my two cents worth (or may a half cent). With the low yield environment on bonds, it real easy for an income investor to unwittingly change their investment profile and allocation in the quest to obtain yield. Selectively using high quality dividend paying equities is a very sound strategy to gain a boost in yield. But with higher yield comes higher risk and its important for the investor to understand the risk in looking at higher yield and the potential change in allocation. I had one adviser recently recommend I go into some foreign bond and dividend paying funds to get more yield. The problem, is that most of the funds in this area hold a lot of junk rated stuff and euro banks. I have a certain allocation % for junk and I’m not willing to increase it to go after higher yield and I surely wouldn’t invest in any euro banks. A bond portfolio needs to be allocated and diversified just like equities. The question about using FFRHX is a good example. That fund is a short duration fund that holds 95% junk rated securities and, as Paul states, it will move like a stock fund. If you’re ok with upping your allocation to those securities then its a good move. I guess my comment is that we need to be mindful of how we’re changing our allocations and risk profile as we search for higher yields.

    • libertatemamo says:

      Good point Jim and a prudent approach. The risk many income investors forget about is keeping up with inflation and taxes. And most bonds today are priced for negative real yields. In this light conservative dividend paying stocks with rising dividends are lower risk given a long term outlook.


  4. Mike says:

    I am certainly a novice, but enjoy reading your posts. I believe you said at one point that you like NUV so I have a samll position in that since last April on the dip. I like the tax free 4.3% it provides. Do you think I look to move out of NUV and into more MLPs? I already have a small position in KMR.


    • libertatemamo says:

      Hey Mike, I look at munis and MLPs as complementary and not to be swapped for each other. You always need both stocks and bonds in your portfolio. SO my recommendation would be to have both. When you look at munis the alternatives to think about are taxable bonds, when you look at MLPs the alternatives to consider are other types of dividend stocks.

      Hope that helps.


      • Mike says:

        I am reading that the fiscal cliff negotiations and tax code revisions may include a change under which munis may no longer be tax free. Do you think that munis will be taxed and would it be prudent to sell my shares in NUV?

        • libertatemamo says:

          Mike, the proposals on the table are only to limit the muni tax benefit for high income earners, not to eliminate it entirely. While I think its possible this limitation on high income people passes it won’t be easy to get through Congress. It will make state funding more expensive and Congress won’t be too happy about that. Regardless of what happens munis are a good deal at today’s prices, in particular after the sell-off of the last week or so. A great fund like NUV yields about 4.4% vs a taxable funds like TLT or even LQD which yield less than 3%. So even with munis fully taxable they are a better deal than taxable bonds.

          So, while their may be some volatility in the near term, long term they are still a good buy relative to all other bonds.


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