•• When you boil it all down, what does the shifting bond market mean to investors? What is your overall message?
Whether you have existing bond holdings or are looking for new income streams, the same message applies: I believe investors need to broaden their search for income beyond traditional bonds. Those with existing bond portfolios also need to be aware of the risks associated with those holdings, and think about alternative income solutions that might help them make greater progress toward their financial goals. Today’s investors have access to a greater variety of income-generating alternatives than investors did 20 or 30 years ago.
Inflation chips away at portfolio value by degrees…and if it ratchets up, we could see an even greater negative real return on Treasurys.
•• Do you think most investors are fully aware of the bond market risks they are facing?
I suspect that many do not, based on the recent trends in asset flows. Since the financial crisis, investors have funneled billions into bonds, even as yields have continued to drop and risks have increased (Figure 5). In fact, the net flows into bond mutual funds from 2009 through 2012 added up to two-thirds of all net flows going back to 1926.
Because equity funds saw a tide of outflows during this period, we can guess that the move into bonds was driven in part by investors’ fears of another stock market meltdown in this climate of economic and political uncertainty. If so, it’s highly ironic-because in their flight to perceived safety, traditional bond investors have put themselves at high risk of investment losses. Those who fled the stock market also missed a strong market rally.
If you think about it, anyone who didn’t start investing before 1981 has had no experience other than rising bond prices and declining yields. So a whole generation of investors has had no personal exposure to a bearish bond climate and what it could do to portfolios.
Of course, it’s human nature to believe that “things are different this time.” But when you look at the historical patterns, it feels like maybe we’ve been here before. In terms of yields, inflation, and public debt levels, which historically have moved in a tight inverse correlation with yields, I believe the present climate bears some striking similarities to 1941, when we last shifted into a bear bond market.
•• Are you suggesting that it would be prudent for investors to move out of bonds altogether?
No, not at all. There are good reasons why an investor might want to have an allocation to Treasurys or some other relatively safe, shortterm bonds in any market climate, especially if capital preservation and income stability are top priorities.
Given the risks and currently low yields of traditional bonds, I believe investors would be wise to diversify a portfolio that’s heavy in those holdings.
My point is that, in my opinion, investors would be wise to diversify a portfolio that’s heavy on traditional bond holdings. One way to do that is shift some assets from Treasurys to a flexible tactical bond strategy that invests across market sectors, such as tax-free municipal bonds, corporates, and high-yield bonds, and incorporates active risk management, including the ability to sell short. Those kinds of multisector strategies are designed to respond quickly to changing bond market conditions, including rising interest rates.
•• What are some of the other directions that income-focused investors might explore?
Dividend stocks, for one, which historically have been an important source of yield. Investors may not realize that stock dividends accounted for more than 40% of the S&P 500’s total return between 1926 and 2012. As of the end of 2012, the earnings yield of the S&P 500 was 5.3% higher than the 10-year Treasury yield, and 0.6% higher when adjusted for inflation.
Investors might also want to look at more global investment options, including both dividend stocks and bonds. After all, the world’s fastest growing economies are now outside the U.S. Emerging markets have doubled their share of global Gross Domestic Product (GDP) in the last 20 years; they now account for about 38% of the world’s economy. If you want to diversify your income-generating investments, why not consider harnessing that kind of growth?
Real estate is another potential income source. Owning shares of Real Estate Investment Trusts (REITs) lets individuals invest in major commercial properties like high-rise office buildings. By law, REITs must distribute 90% of their operating income to investors each year if they want to avoid paying corporate income taxes, and over the past 30 years they have provided fairly stable yields averaging about 8% annually.
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There are risks involved with investing, including loss of principal. Past performance does not guarantee future results, share prices will fluctuate and you may have a gain or loss when you redeem shares.
Diversification and asset allocation do not assure profit or protect against risk.
There is no guarantee the companies in our portfolio will continue to pay dividends.
Today’s investors have access to a greater variety of income-generating alternatives than investors did 20 or 30 years ago.
•• When you talk about rotating into stocks, it raises some concerns. If investors were afraid of the stock market before, won’t they be even more so now that the market has had an extended rally?
Investors are right to be cautious. History tells us that periods of strong stock market rallies are usually punctuated by market corrections or pullbacks, and over the long term, the market has had one down year out of every four years, on average. On the other hand, the stock market has outperformed bonds for several decades, albeit with greater volatility.
Based on the economic data we’ve been seeing lately, I’m also of the opinion that economic growth may be picking up somewhat, both in the U.S.and abroad, which would bode well for stocks. For example, median home prices in the U.S. have been slowly rising over the past year or so, giving household balance sheets a boost. The employment picture appears to be improving, if slowly; as of the end of 2012, total unemployment claims are down by more than 50% from their June 2009 peak.
As for corporate and individual debt, those levels have declined since they peaked around October of 2009. That is significant, since high debt levels across the board were one of the primary triggers of the 2008 financial crisis.
These factors won’t eliminate the risk of stock market downdrafts, but they do speak to the market’s balance of risk and reward over the longer term.
•• What about our stratospheric government debt levels? Isn’t that a cause for concern?
It’s true that U.S. debt levels are high, but they’ve been higher in the past. U.S. government debt is projected to rise to 108% of GDP by 2014; in 1944, the ratio was 120%. Remember that 1941 was the start of the bear market for bonds and rising relative values for stocks. Back in the early ’40s, the relationships between traditional bond yields and public debt were very similar to those today (Figure 6).
Figure 6. Trends in Public Debt and Bond Yields Echo Those of 1941
U.S. Government Debt as a Percentage of GDP vs. Traditional Bond Yields
January 1, 1929 – December 31, 2012
Source: U.S. Treasury; Ibbotson Associates
Based on Ibbotson Associates SBBI U.S. Intermediate-Term Government Bond Index
Past performance does not guarantee future results.
This doesn’t guarantee that the same pattern will be repeated going forward, of course, but the historical view is consistent with the trends we’re seeing now. To my mind, that suggests that the economy should be able to continue growing despite our level of public debt. We’re also seeing moves to rein in government debt around the globe, and that is encouraging.
Alternative income strategies historically have displayed higher volatility than traditional bonds, but have also delivered better risk-adjusted returns.
•• You’ve made a strong case that bond investors need to rethink their positioning. So what should income-focused investors think about doing now?
No one knows the future with certainty, but we can make an educated guess about what might happen by analyzing how a mix of income-generating investments would have performed during historical conditions resembling the ones we seem to be heading into now.
Based on my belief that we’re shifting into a bear market for bonds, our first analysis looked at how a diversified income portfolio would have performed during the 1941-81 bear market.
We found that over that period, a hypothetical equally weighted portfolio of high-yield bonds, dividend stocks, and foreign bonds would have delivered a total return 4% higher than traditional U.S. government bonds, including 0.8% more annualized income. Most important, the hypothetical diversified portfolio produced a positive return after adjusting for inflation, which the traditional bonds did not (Figure 7).
Figure 7. A Diversified Income Portfolio Did Well in Historical Testing
Historical Asset Class Performance during the Bond Bear Market
January 1, 1941—December 31, 1981
Source: Ibbotson Associates
Past performance does not guarantee future results.
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