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The bond party is over

Bonds were never designed to provide high returns but to provide security

Apr 22, 2014 @ 12:01 am

By J. Brent Burns and Stephen J. Huxley

The rise in interest rates since the historic low in 2012 has many bond fund investors running for cover, much to the consternation of Pacific Investment Management Co.'s chief executive Bill Gross. And if one looks at rates over the long term, run they should!

No one can forecast where rates will go over the next few years but a cursory examination of the chart below suggests it is unlikely they will follow the pattern they have followed over the past 33 years, when they reached their peak in 1981. This chart provides a long-term perspective on 10-year Treasury yields back to 1800. The dramatic drop that is quite evident in the chart has made many bond fund managers rich and lulled many investors into thinking total returns on bonds are almost as good as equity returns.

But the party is over.

The most important take away from this chart is that bond yields are beginning to move back toward familiar territory. The next most important take away is to serve as a reminder that bonds were never really designed to provide high returns. They were and are designed to provide security.

(Get the lowdown on first quarter bond ETF returns.)

Unlike most financial instruments, a bond's future value is predictable if held to maturity. Indeed, given the higher returns that equities offer over the long run, bonds really only make sense when held to maturity, unless you have a crystal ball for timing the market.

Many bond fund managers, unfortunately, believe they have a crystal ball that really does work. They do not hold bonds to maturity. Rather, they trade them, based on what they think rates will do. And too many advisers have treated bond funds as sluggish stocks funds. They believe that investing in bond funds fulfilled Modern Portfolio Theory's commandment that “Thou shalt hold X% equities, Y% fixed income, and Z% cash.” This XYZ strategy worked pretty well over the past three decades. But total returns on bonds are unlikely to repeat this experience in the future. Bond fund investments may now become a liability in client portfolios.

(Don't miss: Navigating the edges of fixed income)

A better strategy going forward is based on Dedicated Portfolio Theory. Modern Portfolio Theory focuses on short-term returns, and Sharpe ratios typically are based on three-year moving averages. But most clients expect planners to develop lifetime financial plans covering 30, 40 or even 50 years. MPT's focus on the short run confuses matters. DPT focuses on dedicating the portfolio to meeting long-term goals.

The DPT strategy is especially useful for retirees. Its approach is to buy an “income portfolio” consisting of laddered bonds designed to match the withdrawals needed for income over the next five to 10 years. Everything else is invested for growth. By holding each bond to maturity, the income it produces is immunized from the vagaries of the market. It establishes a floor on income that is far more predictable than any other financial investment.

Dynamically, as each year passes, the maturing bond can be replenished by selling enough equities to buy a new bond to extend the ladder another year, making up for the bond that just matured. In this fashion, the income portfolio can be extended indefinitely, or at least as long as the growth portfolio holds out. If no withdrawals are needed, funds from the maturing bond can be rolled over to another bond to maintain the original length of the ladder.

So what's the bottom line?

Smart advisers are getting their clients out of bond funds while the getting is good, and switching to individual bonds with the intention of holding them to maturity. With yields as low as they are now, this strategy will not make your clients rich, but it will keep them safe.

J. Brent Burns is president and Stephen J. Huxley is chief investment strategist of Asset Dedication

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