Bonds should be the least amount of trouble in setting up or managing a portfolio. Here are some essentials to consider before setting your bond allocation.
Ok, here we go with the basics for bond investment selection and management:
Think About Your Allocation to Bonds Versus Stocks
There is a big difference for a portfolio with 20% bonds versus one with 80%. If you have minimal bond exposure, I assume you have correctly set the risk tolerance for that. If you have a low bond allocation, then you want the greatest “bang for your buck.” The logic is that if you are carrying a low bond allocation, you are going to be more concerned about how well or poorly bonds will help you cushion those inevitable stock declines. If you want bonds to maximize the potential benefit, yet do so within a small bond allocation, you need to consider increasing bond duration, and reducing default risk. That means using longer duration treasury bonds. The idea is that during stock market declines investors tend to flee to treasuries, and the longer term issues tend to have the greatest positive return during these periods. Of course, that will not always be the case, especially if the stock declines coincide with more than a modest increase in interest rates. Stock declines also can signal declining profits and increased business uncertainty. That can negatively affect corporate bonds, since they have default risk in addition to interest rate risk. Bottom line: the smaller the bond allocation, the longer the duration and the safer the bonds need to be.
Understand the Primary Purpose of Bonds in a Portfolio
A common investing fallacy is you need to select bonds that will provide the best return. We all want great investment results, but long-term, you will maximize returns by investing 100% long term in stocks, and avoid bonds altogether. The problem is we are human and stock declines never look that bad until you actually have to live through a serious bear market. The primary reason we hold bonds is not for their return per se, but for their role in reducing the overall volatility of the portfolio. We still want to keep up with inflation, which is quite a challenge in a low interest environment. With this in mind, you should (1) first set the correct allocation to bonds versus stocks. It the single-most important decision you will make in all the investment choices you will make; then, (2) look to maximize returns, but by selecting only safe investment grade bonds to be the “sleep well” part of the portfolio. Yes, the higher-grade bonds will provide a lower return for the lower risk. Therefore, consider increasing duration so you might at least obtain a real return after inflation. It is better to take interest rate risk than to increase your default risk. If you are considering below-investment-grade bonds to juice bond returns, consider instead increasing your stock allocation. If you are going to increase your overall portfolio risk, then expect the highest risk-adjusted return. You will find that in stocks, not bonds. At Bogleheads, they say “take your risk on the stock side, not on the bond side.” High yield bonds provide a higher nominal yield than investment-grade bonds, and also provide added portfolio diversification in that they can perform differently to both stocks and bonds depending on market conditions, but critics charge that risk-adjusted returns are just not favorable to the investor.
Reconsider Diversification, and Then Consider Convenience
Stocks are very risky investments, and if you invest in a single company, you can lose 100% of your investment. When you diversify stocks by adding a number that approaches the entire stock market, you eliminate “single stock risk.” The idea is that investors are not compensated for single stock risk because stock markets are efficient.
Bonds are different from stocks. Investment grade bonds are a superior claim to a company’s assets over those from its stockholders. The terms are detailed in the bond indenture. Even in the event of a bankruptcy, bondholders are likely to get at least something out of their corporate bond investment. Still, if you hold corporate bonds, even investment grade ones, you can lose a lot if you do not diversify, and the bond side is not where you want to take risk. If you invest in corporates, you should choose only investment grade, and keep duration to intermediates or shorter. For most investors, use a well-diversified bond fund rather than purchase individual bonds.
Treasuries are different from corporates. Treasuries do not have default risk because the U.S. Government backs them. This means diversification is not needed at all. It does not matter whether you buy one treasury bond or 200, the default risk is still zero. You can buy U.S. Treasuries directly from the Government through their TreasuryDirect website. You hold your securities directly in your own treasury account, and funds can be transferred directly to and from your bank account at no cost to you. So then why are there Treasury bond funds? Convenience. If you are making regular deposits you can automatically buy shares in a fund, and you can automatically reinvest dividends paid every month for more shares. If you use TreasuryDirect, you have to buy securities at auction, and each auction is for a different duration. If you need to buy a 5-year, but the next auction is a 10-year, you have to wait. You also have to be mindful of maturing bonds, and reinvestment of individual securities. The timing and term of the bond affect the duration of the portfolio. That said, if you only need to own a few treasuries, and you are going to hold them for 10 or more years until redemption, it may not be too much trouble. In fact, for high bond allocations (70-80%) of high net worth investors, this is a preferred way because of the savings in expenses over the long-term. That said, Vanguard Intermediate-Term Treasury Fund Admiral Shares (VFIUX) (minimum investment $50K) has the lowest expense ratio I have found: 0.10%. That amounts to $1,000 per year per $1 million invested. If you have $1 million in bonds, is it worth $10,000 total for managing them by yourself for ten years? You decide.
Diversification of Bond Types
This is an area in which many very intelligent people can disagree. I am venturing into opinion in hopes you can use this to decide for yourself other bond investments appropriate for you. For many investors, a “total bond market” fund is enough for the entire bond allocation. Keeping it simple this way is the right way for many.
TIPS – Treasury Inflation-Protected Securities, or TIPS, provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater. These can be purchased directly through TreasuryDirect, or through purchase of a mutual fund. Given the limited number of bond terms, and therefore difficulty setting up a bond ladder with such bonds, many use a TIPS fund rather than buy individual securities, but diversification of TIPS is not required either if you do not need staggered maturities (a bond ladder). TIPS can provide some protection against unexpected inflation, and is widely-used in bond portfolios to diversify interest rate risk.
I-Bonds – I Bonds have characteristics similar to TIPS, but are different in two ways. First, the bonds can only be purchased directly from the treasury by the investor, and second, the interest rate applied to the bonds is adjusted each six months based on the CPI-measured inflation rate. Many view I-Bonds as more attractive than TIPS. One big problem: the Treasury limits the amounts you can purchase each year.
Municipal Bonds – If you have a lot of money in taxable accounts, or otherwise cannot complete your allocation to bonds without including taxable accounts, consider munis. Although munis are considered Government bonds, they are more illiquid than even corporate bonds. For reasons of liquidity, most investors should only use mutual funds with a diversified portfolio of bond holdings. Depending on the state you live in, you may need to choose a fund that includes state-level tax exemption. Compare the expected return with the expected after-tax return of a taxable bond fund, and you may find munis are much more attractive. Despite what you may have read about the risk of municipalities going bankrupt, the risk for investment grade munis is tiny relative to the risk of investment grade corporate bonds.
Foreign Bonds – If you decide to include foreign bonds, I would suggest using only the Vanguard Total International Bond Index Fund Admiral Shares (VTABX), because it is currency-hedged and is the only one with low enough expenses to make it worth the potential benefit. Foreign bonds can perform differently, and for large bond allocations, a slice to foreign this way is probably a good idea.
No-Robo guy avoids foreign bonds and high yield bonds, and his fixed income portfolio is mostly intermediate treasuries, with slices to TIPS/I Bonds, investment grade corporate bonds, and high yielding (but FDIC-insured) savings accounts. Which brings me to the last category…
FDIC-insured Accounts – This category includes any account in a U.S. bank and for which there is FDIC or FCUA (credit union) insurance coverage for the amounts invested. For example, Consumers Credit Union currently pays 4.59% on cash balances up to $20K when you jump through a few hoops. Many other accounts pay 1% or so for shorter term cash needs. Certificates of Deposit can also be an attractive option for shorter term balances.