why do we invest in bonds with negative real return?

[pkcrafter]

JesperDall wrote:

FYI: When I see the portfolios of the average do-it-yourself investor, the answer is usually to go "high yield" with little or no understanding of the risk implications - the main reason being that "bonds are bonds, so I might as well get paid for holding them"...

You're right about this, I see many posters on M* and some here too that are moving into high-yielding bond funds and dividend paying stocks to avoid bond risk. The problem is they do not believe they are increasing risk--or they choose to think that way to justify their actions. I think if investors want to change AA by moving into high-yielding bond funds they should cut back on equity in order to maintain risk profile.

The main thing that strikes me as strange is investors wanting to move out of bonds because of the risk they can clearly see and calculate. Stocks are riskier than bonds, but because stock risk isn't right there on the top of the table investors seem to think it isn't there at all. High quality bonds are not riskier than stocks, not now, not ever. What do investors do when the market drops 50%, they endure it. Now with bonds it's the same thing, only it won't be a 50% drop. Obviously we are going to see inflation rise at some point and we know what it will do to bond funds. The knowing does not increase risk, it decreases risk. So, shorten up the duration and ride it out. If income or lifestyle is effected an investor could ratchet up the risk, but there certainly is no guarantee that will pay, especially in the relatively short term.

Paul

[SpaceCommander]

I too have struggled with the idea of continuing to invest in an asset class that is expected to provide negative real returns. Where will the nominal return come from? Dividends? They're practically zero. Capital gains? With interest rates near zero, we can hardly expect falling rates to continue to juice our returns. To the contrary: we're looking at capital losses when rates rise (offset by our miniscule dividends, mind you.)!

So I made the best call I could under the circumstances: I liquidated my bonds and eliminated that huge negative bond in my portfolio. There's a guaranteed, risk free real return right there. It helps to control my overall risk, but now rebalancing is an issue. Alas, no perfect solution in sight... But I sleep well under my own roof.

JC

[pkcrafter]

SpaceCommander wrote:

So I made the best call I could under the circumstances: I liquidated my bonds and eliminated that huge negative bond in my portfolio.

What negative bond? What did you do with the money that was in bonds--money market, CDs or stocks??


Paul

[Grt2bOutdoors]

SpaceCommander wrote:

So I made the best call I could under the circumstances: I liquidated my bonds and eliminated that huge negative bond in my portfolio.

What negative bond? What did you do with the money that was in bonds--money market, CDs or stocks??


Paul

Elimination of debt? - a mortgage perhaps?

[pkcrafter]

SpaceCommander wrote:

So I made the best call I could under the circumstances: I liquidated my bonds and eliminated that huge negative bond in my portfolio.

What negative bond? What did you do with the money that was in bonds--money market, CDs or stocks??


Paul

Elimination of debt? - a mortgage perhaps?

That sounds reasonable if not likely, although I don't consider debt a negative bond. But then is the portfolio now all stock?

Paul

[SpaceCommander]

SpaceCommander wrote:

So I made the best call I could under the circumstances: I liquidated my bonds and eliminated that huge negative bond in my portfolio.

What negative bond? What did you do with the money that was in bonds--money market, CDs or stocks??


Paul

Elimination of debt? - a mortgage perhaps?

That sounds reasonable if not likely, although I don't consider debt a negative bond. But then is the portfolio now all stock?

Paul

Often we hear mortgages described on this board as "negative bonds". I liquidated my fixed income portfolio and paid off my house. Indeed, what's left of the portfolio is now all stock.

Whereas, before I had a fairly conservative split between stocks and bonds along with a few hundred thousand in mortgage debt, now I have 100% stock with zero debt. I'm completely debt free, but the actual dollar amount that I have in equities hasn't changed at all. I also have a very stable job (military), a forthcoming pension, and a significant monthly surplus. So that might impact my overall risk tolerance too.

Bottom line: I think debt elimination makes for excellent "fixed income" investing under these circumstances. At least you're getting an expected REAL return!

JC

[Valuethinker]

I cannot tell you how interesting and depressing it is to listen to the very best of the bogleheads discuss the bond market.
The difficulty of the current market is an absolute major headache for someone 5-10 years from retirement trying to protect what they have but need to make a little more.What about individual corp bonds from blue chip companies of maybe 3-5 year duration?Does that not help address the problem with the bond funds?I would think buying a bond from say Intel or GE or the like,is more definite in terms of risk and return than buying the stock?

hoops - if you think it's depressing now, then wait until you're actually in retirement (as I am) when fixed income investments become a really big deal. The term "financial repression" has been used to describe the effects of central bank actions on us, and it won't be much better in 5-10 years because the best predictor of what you'll be earning then from fixed income is what is being earned now. Work longer, save more, and plan to spend less.

Annuity rates are also hit (my expected retirement income has something like halved in 5 years-- by law in the UK you must annuitize at a certain point) however you still get the mortality credit (shrinking years of average expected remaining life).

In other words, a higher income from the same capital.

So it pushes one (even more) towards annuitization.

[Default User BR]

Often we hear mortgages described on this board as "negative bonds". I liquidated my fixed income portfolio and paid off my house. Indeed, what's left of the portfolio is now all stock.

Yowser. You massively increased your risk profile by eliminating some of the cheapest debt ever. The mind boggles.

Bottom line: I think debt elimination makes for excellent "fixed income" investing under these circumstances. At least you're getting an expected REAL return!

I could not disagree more. You're giving up one of the best hedges against potential future rate increases and inflation that you can get right now.


Brian

[richard]

Richard I am afraid I place a more central role on financial intermediation in the economy.

It's something our models have traditionally ignored, but I think a wealth of emerging market crises, before the Great Recession, plus of course history dating back to the 19th century at least, says that when financial intermediaries go broke the shock is multiplied throughout the real economy. I think Paul Krugman (and others, who he credits) have models of 'balance sheet recessions' which show this-- and this goes back to Minsky (at least).

Thus what would have been a nasty recession is turned into something worse-- a lot worse. And still going on in Europe. UK GDP is below its 2008 level and will be until c. 2015-2018, and I think that's a measure of the depth of the financial crisis (bad policy responses probably have not helped).

The collapse of the housing bubble directly lowered spending by over $1 trillion out of a total of $15 trillion. How much of a decline in GDP and employment would you expect? Given that government refused to fill the gap, what else would you suggest would fill the gap and how long would you expect that to take?

Regarding the UK GDP, bad policy responses go way beyond "probably have not helped" IMO. Look at any of the charts correlating changes in government spending with changes in GDP in major economies. We're coming as close as you can in the real world to running a test of the idea that contractionary policy is contractionary.

[richard]

hoops - if you think it's depressing now, then wait until you're actually in retirement (as I am) when fixed income investments become a really big deal. The term "financial repression" has been used to describe the effects of central bank actions on us, and it won't be much better in 5-10 years because the best predictor of what you'll be earning then from fixed income is what is being earned now. Work longer, save more, and plan to spend less.

Every major economy which issues debt in its own currency and which has controls its own monetary policy (including close cases, such as Germany), has very low interest rates, despite rather different central bank actions.

Higher interest rates would lower portfolio values. While the higher rates results in higher values over the long term (duration of portfolio) if you reinvest cash flow, that doesn't really help retirees.

You're absolutely right that current yields are the best predictor of future yields (best as in better than alternative prediction methods) and that lower returns mean you need more savings, lower spending or both. However, lower rates contribute to stronger stock performance, so diversification should help.

[hazlitt777]

However, lower rates contribute to stronger stock performance, so diversification should help.

Diversification helps, but not because of lower rates. I believe the lower rates do not so much contribute to stronger stock performance, just the inflation of their nominal performance. We could be looking at a bit of a bubble there rather than true growth.

[SpaceCommander]

Often we hear mortgages described on this board as "negative bonds". I liquidated my fixed income portfolio and paid off my house. Indeed, what's left of the portfolio is now all stock.

Yowser. You massively increased your risk profile by eliminating some of the cheapest debt ever. The mind boggles.

Bottom line: I think debt elimination makes for excellent "fixed income" investing under these circumstances. At least you're getting an expected REAL return!

I could not disagree more. You're giving up one of the best hedges against potential future rate increases and inflation that you can get right now.


Brian

We've had this conversation over and over on this board. No need to repeat it here. I fully understand your position. I'm not sure you understand mine. Tell me again how I INCREASED my risk profile by becoming debt free? I understand the inflation hedge and the opportunity cost. I'm looking at it as the "fixed income" side of my portfolio which now is throwing off a POSITIVE real return instead of investing in bonds which have an expected negative real return. My paid off real estate should provide some inflation protection, and with zero debt, I'm not interested in hedging against rising rates.

Put it this way: with my house paid off, would I be interested in mortgaging it at today's attractive rates and putting the proceeds into bonds? That's an easy one: absolutely not! To mortgage my home and put the proceeds into an investment with expected negative real returns? Go ahead and knock yourself out... I'll pass.

Indeed, the current conditions are making people do crazy things like: 1) holding bonds with expected negative real returns, or 2) paying off all debt and becoming debt free! How crazy is that?

JC

[larryswedroe]

Negative bonds
This is one of the most common mistakes investors make, failing to account for all the assets and liabilities on their balance sheet
The most common error in my experience is to forget to include their labor capital, asking if you're a stock or a bond, in their decision on asset allocation
The second is failing to account for the debt on their balance sheet, which is negative fixed income.

Clearly someone with no debt can take more equity risk, and more labor capital risk as well, and that is one of the benefits of paying down debt, besides it allows you to sleep well and be less at risk of panicked selling

Also paying off the mortgage is generally going to be the highest risk free return you can earn.

Having said that one should consider that a FIXED RATE mortgage does provide inflation hedge--and you can always pay off early if rates fall. So one should consider the option when doing the math on whether to pay off or make a fixed income investment.

I hope that helps.

Best wishes
Larry

[tadamsmar]

It's not unusual for someone to stress out about the direction that an asset will go as if they know which way it will go.

But it's kind of odd to stress out about the negative returns of bonds when they are giving good positive real returns as they are today. It's obvious why we hold them in our portfolio if you just look at the behavior of a diversified AA.

I am looking forward to the day when bonds drop, stocks shoot up to a PE of 20, my overall portfolio will have done nicely, and, of course, someone will be writing posts based on the assumption that stocks are certain to give a negative real return.

[Default User BR]

I'm looking at it as the "fixed income" side of my portfolio which now is throwing off a POSITIVE real return instead of investing in bonds which have an expected negative real return. My paid off real estate should provide some inflation protection, and with zero debt, I'm not interested in hedging against rising rates.

100% stocks is an extremely risky portfolio. You have to do some real mental gymnastics to consider that less risky than an allocation to bonds (even if you assume a negative return going forward) and a low-rate fixed debt obligation.


Brian

[bdpb]

I'm looking at it as the "fixed income" side of my portfolio which now is throwing off a POSITIVE real return instead of investing in bonds which have an expected negative real return. My paid off real estate should provide some inflation protection, and with zero debt, I'm not interested in hedging against rising rates.

100% stocks is an extremely risky portfolio. You have to do some real mental gymnastics to consider that less risky than an allocation to bonds (even if you assume a negative return going forward) and a low-rate fixed debt obligation.

It's not the percentage of stocks that makes a portfolio risky. It's the absolute number of dollars in stocks.

[athrone]

Often we hear mortgages described on this board as "negative bonds". I liquidated my fixed income portfolio and paid off my house. Indeed, what's left of the portfolio is now all stock.

Yowser. You massively increased your risk profile by eliminating some of the cheapest debt ever. The mind boggles.

He didn't touch his stocks, thus the equity side of his risk profile stays exactly the same. On the fixed income side he reduced his risk profile because the risk of a bond (non zero) is greater than the risk of debt (zero). Very smart move IMHO.

-athrone

[athrone]

I'm looking at it as the "fixed income" side of my portfolio which now is throwing off a POSITIVE real return instead of investing in bonds which have an expected negative real return. My paid off real estate should provide some inflation protection, and with zero debt, I'm not interested in hedging against rising rates.

100% stocks is an extremely risky portfolio. You have to do some real mental gymnastics to consider that less risky than an allocation to bonds (even if you assume a negative return going forward) and a low-rate fixed debt obligation.

Brian,

The bonds (or stocks) are essentially bought on margin if you have other debt. What's riskier than 100% stocks? 100% stocks + leverage. Also, why would you take on debt to turn around and invest it in something that earns a negative real return? Makes no sense.

-athrone

[sls239]

However, does that rule out bonds as an asset class? Vanguard's Total Bond Fund currently has a Yield to Maturity of 1,65%, which is below most inflation estimates.

I want to challenge you (and myself!) and the reasons why long-term investors should hold bonds when the very basics tell us to exclude them.

I'm a little confused as to what you mean by inflation estimates. Yield to maturity indicates future return, so am I correct in assuming you are speaking of inflation predictions?

If so, then one of the very basics is that I accept that neither I nor anyone else can reliably make a better prediction of the future than what the market is reflecting right now. A YTM of 1.65% is an inherent inflation prediction that the market has created in the same way a stock price is a prediction of future earnings. I have no good reason to believe I could make a better guess as to what it will be.

In November of 2011, Vanguard's TBM index YTM was 2.4%. If I've got my number's right, inflation for the past year was about 2.4%. For what it's worth.

IMO, the negative real return offered by TIPS is an insurance policy, and one that I don't feel the need to purchase.

[john94549]

My wife has a bond fund for re-balancing, if necessary. Based on my S/S COLA adjustment, somebody thinks inflation was 1.7% last year. I can get a 5-year IRA CD at 2%. It's not much, but it's not negative.

I've discussed building a CD ladder from existing bond funds in other threads. While CD ladders are much too cumbersome for purposes of re-balancing one's AA should the need arise, one solution is to have enough in bond funds to re-balance once or twice (when bands hit)*, and then use a maturing CD ladder rung (or part thereof) for more, if necessary.

*As noted by others, it takes a full-blown correction (a stock market drop of 20%) to trigger a typical 5% re-balancing band. Take a typical 50/50 AA with a $1M portfolio. A 20% correction results in a portfolio with $400K in stocks and $500K or maybe a tad more in fixed-income. For ease of math, I'll assume the fixed-income remains static at $500K. You bring the portfolio back to 50/50 by moving $50K to stocks from fixed-income. Should the market continue down another 20%, you move $45K from fixed-income to stocks. Thus, even in the event of two "bands" being hit, $100K in bond funds would be ample. You can adjust the math for your particular AA and portfolio size.

[Humbled]

For some historical guidance, it is interesting to use the tool available on the Vanguard website, which shows that both cash and bonds had negative real returns from 1941-1981. This is a 41 year long period! The tool then allows the user to adjust the proportions of stocks, bonds, and cash.

Adding stocks and cash to bonds increases the real return and increases volatility. For example, with a portfolio of 40% stock, 45% bonds, and 15% cash, there was approx 2% real return, and a 22% largest one year loss:
https://personal.vanguard.com/us/insigh ... about-risk

Consequently, one solution to negative real bond returns is to add equity to the allocation.

This tool uses the US stock market, and I suspect that the results might be better if ones equity allocation includes REITS and ones bond allocation includes tips and/or Ibonds. If the equity allocation includes a value tilt, there may also be some further inflation protection, since these companies are more leveraged.

I am not sure if this tool uses yearly rebalancing, band rebalancing, or some other means to keep the allocation constant.

[tadamsmar]

For anyone who believes they have a better alternative to bonds: beat the Sharpe Ratio for the year 2013 of 50/50 VTSAX/VBTLX by substituting some shorter bond or money market funds that are just as widely available as VBTLX. You must substitute for the bond allocation only, leave the stock allocation as is.

Bondphobia has been rife for years. I put a similar challenge out 2 years ago: viewtopic.php?t=65069

[dbr]

Adding stocks and cash to bonds increases the real return and increases volatility. For example, with a portfolio of 40% stock, 45% bonds, and 15% cash, there was approx 2% real return, and a 22% largest one year loss:
https://personal.vanguard.com/us/insigh ... about-risk

Consequently, one solution to negative real bond returns is to add equity to the allocation.

That solution is the standard behavior of stocks and bonds at any level of return but it is not a solution as the conventional constraint is to not increase volatility. Getting more return at more volatility is always an option but can be painful in the outcome.

[Valuethinker]

However, does that rule out bonds as an asset class? Vanguard's Total Bond Fund currently has a Yield to Maturity of 1,65%, which is below most inflation estimates.

I want to challenge you (and myself!) and the reasons why long-term investors should hold bonds when the very basics tell us to exclude them.

I'm a little confused as to what you mean by inflation estimates. Yield to maturity indicates future return, so am I correct in assuming you are speaking of inflation predictions?

If so, then one of the very basics is that I accept that neither I nor anyone else can reliably make a better prediction of the future than what the market is reflecting right now. A YTM of 1.65% is an inherent inflation prediction that the market has created in the same way a stock price is a prediction of future earnings. I have no good reason to believe I could make a better guess as to what it will be.

In November of 2011, Vanguard's TBM index YTM was 2.4%. If I've got my number's right, inflation for the past year was about 2.4%. For what it's worth.

IMO, the negative real return offered by TIPS is an insurance policy, and one that I don't feel the need to purchase.

The difference between the TIPS and the Treasury Nominal Bond of the same maturity is the market's estimation of inflation.

Technically

(1+ YTM nominal)/ (1+ YTM real) = (1 + breakeven inflation)

Currently running about 2% I believe.

If in holding the bond to maturity, you only experience *expected* inflation, then you are neutral between the 2 bonds.

If inflation exceeds BEI, then you were better off in the TIPS. If it falls below, you were better off in the nominal bond (ie inflation outturn was below inflation expectation).

http://www.clevelandfed.org/research/da ... /index.cfm

Note the Cleveland Fed stopped using the 'pure' TIPS measure in late 2008 due to liquidity issues with TIPS (real yields shot up to 3.0% post Lehman).

https://www.vanguard.co.uk/documents/ad ... -bonds.pdf

http://www.calculatinginvestor.com/2011 ... ectations/

(as per previous threads, Bloomberg has stopped making the data available for free, alas)

[pastafarian]

I'm looking at it as the "fixed income" side of my portfolio which now is throwing off a POSITIVE real return instead of investing in bonds which have an expected negative real return. My paid off real estate should provide some inflation protection, and with zero debt, I'm not interested in hedging against rising rates.

100% stocks is an extremely risky portfolio. You have to do some real mental gymnastics to consider that less risky than an allocation to bonds (even if you assume a negative return going forward) and a low-rate fixed debt obligation.
Brian

Clearly I possess a flexible set of mental accounting muscles. I immediately recognized SpaceCommander's actions as something I would/could do in the same set of circumstances. Being debt free but lacking a military pension (in my future) we are staying the course with 60% TBM.

[Dale_G]

I am betting that TP and Forever postage stamps will keep up with inflation - and unlike TIPS, there will be no tax due when the assets are "redeemed".

Total Bond Market, or longer or shorter - you have to just grit your teeth and put up with it. After all, the borrowers need someone to bail them out - and the savers are it.

Dale