Beauty of bonds lost in stampede to the exits

Investors losing sight of need for volatility buffer; many jumping on far riskier bandwagons

Jul 16, 2013 @ 2:41 pm

By Jeff Benjamin

After a 30-plus-year bull market in bonds and a few years of stern warnings that rising interest rates can hurt bond prices, there now are concerns that some investors might be taking the message to extremes.

Although it is true that rates are at record lows and that a rising rate environment will drive down prices of existing bonds, the growing focus on alternatives to bonds could be planting the seeds for a new kind of risk.

“For the folks who are really trying to find noncorrelated and less volatile investments, bonds fit that profile, and people own bonds because there is some kind of financial plan, whether it is stated or not,” said J. Brent Burns, president of Asset Dedication LLC.

All the recent fund flow data from the likes of the Investment Company Institute and Morningstar Inc. show that investors have been jumping on the alternative-to-bonds bandwagon.

One of the more popular income-producing alternatives has become dividend-paying stocks. But the list of alternatives to boring old high-quality bonds also includes emerging-markets debt, commodities, real estate investment trusts and high-yield bonds.

“The question I always ask is, if not bonds, then what?” said Chris Philips, a senior analyst in the investment strategy group at The Vanguard Group Inc.

“If you are moving out of bonds into something else, all of those other strategies come with different and potentially greater risk than the bonds you are leaving,” he said. “The minute you try to replace fixed income with stocks, they will start performing like stocks because stocks never are and never will be bonds.”

Nobody really can blame an adviser for trying to capture a bit of extra income by trimming some bond exposure in exchange for some dividend-paying blue-chip stocks.

But what has analysts such as Mr. Philips concerned is the degree to which some portfolios have gotten out of balance.

Sure, there are plenty of dividend-paying stocks and high-yield bonds that have been able to surpass high-quality corporate bonds in the income department. But let us not forget the other significant benefit of fixed income in a portfolio, which is to act as ballast against market volatility.

For an illustration of how reaching for extra income can ramp up portfolio risk, Mr. Philips points to the median monthly performance of a dozen popular asset classes during periods of bottom-decile returns between 1988 and 2012.

For U.S. equities, the median return during the worst monthly periods during the 24-year stretch was a decline of more than 7%.

Emerging-markets stocks did even worse, with a decline of nearly 9%.

Dividend-paying stocks fell by nearly 4%.

Even high-yield bonds and emerging-markets debt produced declines of 3% and more than 1%, respectively.

But U.S. investment-grade corporate bonds, international investment-grade debt and U.S. Treasury bonds all produced positive median monthly returns of between 0.5% and 1.5% during the worst monthly periods over the past 24 years.

“We've seen over the past couple of years a lot of investors moving out of traditional fixed income and into things that have increased duration exposure and interest rate exposure,” Mr. Philips said. “If you're making that move out of bonds and into stocks, you better expect tremendous volatility.”

For a more recent example of the kind of portfolio volatility an investor might be courting by dramatically reducing traditional bond exposure, consider the market activity from the April 30 Treasury bond low point through last Friday.

Over that concentrated two-and-a-half-month period, the S&P 500 gained 5.5%, global non-U.S. equities fell by 2%, emerging-markets equities fell by 8.5% and the Barclays U.S. Aggregate Bond Index fell by 3.5%.

Domestic stocks obviously stand out as the best performer during that period, but during the four-week stretch from May 21 through June 24, the S&P 500 suffered a 5.7% drop, and global equities fell by 10%.

Slicing it another way, performance during the heart of the financial crisis, from October 2007 through February 2009, shows another stark example.

U.S. stocks during the period lost 55%, while U.S. dividend-payers lost 57%.

High-yield bonds fell 25.5%, emerging-markets bonds fell 10%, investment-grade U.S. corporate bonds fell 5.9% and Treasury bonds gained 15.4%.

“It call comes down to understanding what role bonds play in your portfolio,” Mr. Philips said. “That role doesn't change, whether bond yields are at 1% and rising or at 15% and falling.”

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