why do we invest in bonds with negative real return?

[Jesper Dall]

To quote Rick Ferri: "Securities that only keep pace with inflation are not suitable for a long-term investor" (All About Asset Allocation, p.94). This is the main reason why Rick does not recommend e.g. commodities as an asset class.

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.

Being an investment adviser, I find that many, if not most, investors have a hard time realizing just how poor the expected return from bonds is. Intellectually, investors understand it, but they don't feel it - yet.

Merry Christmas!

Jesper

[Alex Frakt]

What is the alternative? And how do you make the decision to sell out of that alternative and get back into bonds?

[Jesper Dall]

There is no quick fix, obviously, particularly not if you design your portfolio to the maximum risk you (the investor) can bear.

But it implies that we are willing to modify the criteria for including an asset class in our portfolio to "...we may include an asset class with expected negative real return if we cannot otherwise reduce the risk to the appropriate level (as defined by the investor)...".

If we were not to include this in our evaluation, it is straightforward to answer "when to get back into bonds?": that is considered only when a positive real return is expected (again). It it not a question of market timing, but about being true to your investment philosophy.

Jesper

[Default User BR]

My fixed-income allocation has been 50/50 aggregate bonds and stable-value from the time I developed my portfolio in 2007. I figure that it provide some differential response to changes in interest rates. As Alex says, there's no real substitute for these kind of investments, in spite of the low returns. Fixed-income largely serves as damper on volatility, which is one way of lowering overall risk in a portfolio.

I'm not in favor of changing allocations in response to perceived market conditions. A central tenet of my investing philosophy is that I'm not knowledgeable enough to time the markets in any meaningful fashion. Perhaps no one is, but certainly not me. As such, the only sensible approach is to develop an investing plan and stay with it. So I do.


Brian

[ourbrooks]

The biggest risk for many investors is that they panic and sell during a market downturn. It happens a lot: http://www.bloomberg.com/news/2012-12-24/americans-miss-200-billion-abandoning-stocks.html The financial damage done by holding bonds with negative real return doesn't even come close.

A question I might ask as a financial advisor is, has the client experienced a major market downturn and, if so, did they sell? If the answer to both questions is yes, then holding lots and lots of bonds with negative real return will probably result in higher, but not necessarily positive, long term actual portfolio returns.

[midareff]

To quote Rick Ferri: "Securities that only keep pace with inflation are not suitable for a long-term investor" (All About Asset Allocation, p.94). This is the main reason why Rick does not recommend e.g. commodities as an asset class.

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.

Being an investment adviser, I find that many, if not most, investors have a hard time realizing just how poor the expected return from bonds is. Intellectually, investors understand it, but they don't feel it - yet.

Merry Christmas!

Jesper

VG Intermediate Investment Grade, Intermediate Tax Exempt, GNMA, Hi-Yield and several others are paying monthly amounts that when annualized are in excess of inflation rates. There are more roads to Dublin than TBM. That response aside, when the next Black Swan comes flying by (not if, but when) I want some dry powder to float my next buying (rebalance) trip.

[Joe S.]

If you are truly long term, more than 25 years from retirement, and have a cast iron stomach, you could consider foregoing bonds, and having a 100% stock portfolio for your retirement fund. This is discussed in this Vanguard paper:
http://us.vocuspr.com/newsroom/ViewAtta ... 9a3cda3a41

See figure 3 near the end, where it talks about a "more aggressive glide path."

However most of us are either closer to retirement, or have less of a cast iron stomach. We want lower risk, and there is no good way of getting lower risk without buying something that has a negative expected return after inflation. We have to face the new reality; bonds are likely to underperform inflation.

[pkcrafter]

To quote Rick Ferri: "Securities that only keep pace with inflation are not suitable for a long-term investor" (All About Asset Allocation, p.94). This is the main reason why Rick does not recommend e.g. commodities as an asset class.

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.

Being an investment adviser, I find that many, if not most, investors have a hard time realizing just how poor the expected return from bonds is. Intellectually, investors understand it, but they don't feel it - yet.

Merry Christmas!

Jesper

Why do we invest in bonds with negative yield? The answer is we usually don't. It's true that the current yield in bonds is low, but this is not the norm. The return on total bond since inception (1986) is 6.76% annualized, and the TR this year is 4.26%. Secondly, if you don't want to invest in bonds now, where do you put the money, certainly not in stocks.

Paul

[Joe S.]

Why do we invest in bonds with negative yield? The answer is we usually don't. It's true that the current yield in bonds is low, but this is not the norm. The return on total bond since inception (1986) is 6.76% annualized, and the TR this year is 4.26%. Secondly, if you don't want to invest in bonds now, where do you put the money, certainly not in stocks.
Paul

The return on total bond since inception may have been 6.76% annualized, but few of us expect that to be the return in the near future. Interest rates have dropped significantly since 1986, and that has spurred a great bond rally, but interest rates cannot continue to drop the way they have much longer. We can't live in the past; we have to face the current reality: bond returns are going to be lower.

[Aptenodytes]

I may be in a small minority, but I don't see anything special about negative yields for bonds. The function of bonds is to provide a radically different mix of risk and return within a portfolio that includes equities, so as to bring the overall risk/return profile into a desired target. In the absence of compelling alternatives, bonds that have negative real yield are fine due to the other benefits they bring. For a given level of risk you want the highest return... What side of zero that falls on doesn't really matter to me.

[larryswedroe]

As others have said, we accept it because the safe (little to no credit risk) alternatives have even lower expected returns. The key is to understand that at least IMO the main role of FI in a portfolio is not return, but to dampen the risk of the overall portfolio to an acceptable level. You can take risks more efficiently on the equity side, diversifying it more effectively and earning premiums in more tax efficient manner.
Larry

[rmelvey]

I think it shows you that Mr. Ferri's criteria for security selection is looking at assets in isolation. From my perspective I think it is more important to focus on how something impacts a portfolio's real returns over time, rather than exclude something that looks unappealing in isolation.

[Jesper Dall]

Thx for thoughtful comments from you all.

If we assume that we can determine the financial goals and risk tolerance of the investor, it all makes sense to stick to the overall plan.

However, risk is a very elusive concept to most investors, and their risk tolerance depends on the trade-off between risk and return. As the risk-return plot changes substantially, which it has, so does the reward for taking on more risk. In short, the conservative long-term investor pays a relatively high price for short-term stability.

Being a long-term investor, does that change the way you think of your asset allocation?

Jesper

[garlandwhizzer]

by larryswedroe » Tue Dec 25, 2012 3:38 pm

As others have said, we accept it because the safe (little to no credit risk) alternatives have even lower expected returns. The key is to understand that at least IMO the main role of FI in a portfolio is not return, but to dampen the risk of the overall portfolio to an acceptable level. You can take risks more efficiently on the equity side, diversifying it more effectively and earning premiums in more tax efficient manner.
Larry

I agree with Larry. The major function of bonds in a portfolio is to control risk and in my opinion even if their expected return in real inflation-adjusted dollars over the next decade is zero, you still need them in your portfolio. We have been in a massive bull market in bonds for 30 years when in addition to reducing portfolio volatility they gave outstanding returns. It is unlikely that those same returns are what the future holds for high quality bonds, but they will still provide preservation of capital in equity bear markets which is essential.

Garland Whizzer

[jjustice]

Can insurance ever become too expensive? Some seem to be saying, "No matter what they charge me to hold bonds, I'm holding as much as ever." Buffett says he buys when they put stuff on sale. I suppose he also sells when stuff is expensive. Right now, safety is very expensive. While you may not want to jump completely to a very different allocation, it seems merely inflexible not to respond to prices.

I think that one of the most dangerously false cliches is: "You can't be too safe." We've done some serious damage to ourselves trying to be safe.

John

[larryswedroe]

jjustice
Sure insurance can become too expensive. But that's relative to the issue of can you bear the risk of being uninsured? Think Pascal's Wager.
For example, IMO if the risk premium for unexpected inflation in TIPS were say 1% I think many investors would be better off not buying TIPS and taking the risk of unexpected inflation. But for some investors it might still pay to pay up. Depends on how exposed to that risk you are and the cost of being wrong
Best wishes
Larry

[Browser]

But wouldn't short term bonds or CDs do as good a job as TIPS to help offset unexpected inflation, while providing a liquid reserve that could be used to lock in higher rates if rates do rise? I wonder if TIPS have lost their allure as inflation insurance, even to those who need it the most such as retirees.

[Valuethinker]

The question should be phrased

Negative Expected real return.

We don't know the returns of bonds ex ante, only ex post (looking backwards).

The current yield of a US Treasury incorporates inflation expectations. Measured by the 'Break Even Inflation Rate' the gap in yield with the US TIPS of the same maturity. Around 2%, from memory.

Right now TIPS are paying negative real yields on expected inflation. If inflation exceeds the breakeven rate, then you'd still come out ahead investing in the TIPS.

If you look at Japan, and a 10 year government bond at a nominal yield of c. 0.75%, you will see that it's not a slam dunk that inflation and bond yields will go up from here.

[Valuethinker]

But wouldn't short term bonds or CDs do as good a job as TIPS to help offset unexpected inflation, while providing a liquid reserve that could be used to lock in higher rates if rates do rise? I wonder if TIPS have lost their allure as inflation insurance, even to those who need it the most such as retirees.

The correlation is pretty good with inflation for ST Bonds or CDs. ST TIPS are the best hedge against inflation, empirically, LT TIPS have too great a price volatility (hence the launch of ST TIPS funds).

As I understand US I Bonds, they are even better inflation hedges.

For a long run investor, you are better off in TIPS (LT) because they pay a higher real yield, but the cost will be greater volatility (a strategy of individual buying and holding to maturity of individual bonds does allow you to 'look thru' that).

[Valuethinker]

Can insurance ever become too expensive? Some seem to be saying, "No matter what they charge me to hold bonds, I'm holding as much as ever." Buffett says he buys when they put stuff on sale. I suppose he also sells when stuff is expensive. Right now, safety is very expensive. While you may not want to jump completely to a very different allocation, it seems merely inflexible not to respond to prices.

I think that one of the most dangerously false cliches is: "You can't be too safe." We've done some serious damage to ourselves trying to be safe.

John

Because in being 'too safe' you had too little safety against inflation.

The high returns from stocks in the very long run don't make them a good inflation hedge, per se, the actual correlation between stock returns and rising inflation is negative.

To be safe, what you need are assets designed to index to inflation-- ie TIPS and I Bonds. However TIPS have a lot of price volatility.

[Valuethinker]

My fixed-income allocation has been 50/50 aggregate bonds and stable-value from the time I developed my portfolio in 2007. I figure that it provide some differential response to changes in interest rates. As Alex says, there's no real substitute for these kind of investments, in spite of the low returns. Fixed-income largely serves as damper on volatility, which is one way of lowering overall risk in a portfolio.

I'm not in favor of changing allocations in response to perceived market conditions. A central tenet of my investing philosophy is that I'm not knowledgeable enough to time the markets in any meaningful fashion. Perhaps no one is, but certainly not me. As such, the only sensible approach is to develop an investing plan and stay with it. So I do.


Brian

In other words you have substituted wisdom over knowledge .

It is a wise man who recognizes 1). his own limitations 2). the limitations of the 'experts' and 'gurus'.

Asset returns are fundamentally unpredictable (if you could buy a zero coupon TIPS, you'd know in real terms what you'd get back, that's the most predictable thing in financial markets, I Bonds similar as I understand their construction-- similarly a zero coupon US Treasury (strip) gives you a fixed nominal return, which is virtually useless over any longer length of time because of the risk of unexpected inflation).

So therefore the wise man, which you are, sets an asset allocation that hedges as many different future states of the world as possible, and that suits his 'comfort level' given the inevitable, vertiginous, stomache-lurching swings of financial markets.

I think the movie 'Argo' with Ben Affleck besides being quite thrilling, is salutory for reminding us how very dark those days of the 1970s seemed-- Iranian Revolution, lines and fist fights at gas stations, US humiliated and powerless-- just the scenes of driving through a revolutionary city with bodies dangling from cranes, protesters stopping cars, crazy kids with AK47s suddenly in authority, people being shot on street corners. I well remember (and it still brings a tear to my eye) my parents rousting me out of bed at 6.30 am to listen to President Carter take responsibility for the disaster at Desert One. Before that our TV screens were full of stagflation, the fall of Saigon, civil rights riots, assassinations, Watergate, etc. In that time, the Dow had stood below 1000 for nearly 14 years, and adjusted for inflation had fallen by something like 40%. Bond holders got hurt worse.

And the flares and the sideburns . Or as Doonesbury had it 'to a kidney stone of a decade' .

EDIT: because of taxation, which can change, *all* investment returns are uncertain. If a TIPS bond is held in a taxable account (or the rules on non taxable accounts change) then the returns vary with different levels of inflation (because tax is levied against nominal gains not real ones). I bonds might still be an exception?

[richard]

The biggest risk for many investors is that they panic and sell during a market downturn. It happens a lot: http://www.bloomberg.com/news/2012-12-24/americans-miss-200-billion-abandoning-stocks.html The financial damage done by holding bonds with negative real return doesn't even come close.

Investors, on average, are not hurt by panic selling (other than transactions costs). Remember that for every share sold there is a share bought.

The biggest risk for investors is that their investments do not return enough to fund their necessary expenses.

[richard]

The question should be phrased

Negative Expected real return.

We don't know the returns of bonds ex ante, only ex post (looking backwards).

The current yield of a US Treasury incorporates inflation expectations. Measured by the 'Break Even Inflation Rate' the gap in yield with the US TIPS of the same maturity. Around 2%, from memory.

Right now TIPS are paying negative real yields on expected inflation. If inflation exceeds the breakeven rate, then you'd still come out ahead investing in the TIPS.

If you look at Japan, and a 10 year government bond at a nominal yield of c. 0.75%, you will see that it's not a slam dunk that inflation and bond yields will go up from here.

"Expected" should only be emphasized for nominals.

Japan's newly elected prime minister campaigned on a program to increase government spending, monetize the higher debt and target higher inflation in order to deal with deflation and its slow economy. The Bank of Japan had been targeting 1% inflation and missing the target. The new PM wants a 2% target. Its stock market has been going up on the news. We'll see what happens to bond yields. http://economistsview.typepad.com/timdu ... story.html

[Valuethinker]

The biggest risk for many investors is that they panic and sell during a market downturn. It happens a lot: http://www.bloomberg.com/news/2012-12-24/americans-miss-200-billion-abandoning-stocks.html The financial damage done by holding bonds with negative real return doesn't even come close.

Investors, on average, are not hurt by panic selling (other than transactions costs). Remember that for every share sold there is a share bought.

The biggest risk for investors is that their investments do not return enough to fund their necessary expenses.

Richard, yes. And your definition of 'risk' is the actuarial one, and really the only correct one. Risk is not volatility, simply.

And No. In that panic causes forced liquidation and macroeconomic effects of the horrors of 1929-1933 and 2008-09. In which point, the fundamental growth of the economy and corporate cash flow has been lowered, possibly permanently (the effects on economic output last 10+ years and on individuals for their entire careers and lives) and thus all investors are affected.

Even though stock market losses have been made up, the fall in interest rates has hit annuity rates, and thus retirement incomes. So we haven't really made up the damage of 2007-08.

So the interaction between financial markets and the real economy is also in there.

[richard]

And No. In that panic causes forced liquidation and macroeconomic effects of the horrors of 1929-1933 and 2008-09. In which point, the fundamental growth of the economy and corporate cash flow has been lowered, possibly permanently (the effects on economic output last 10+ years and on individuals for their entire careers and lives) and thus all investors are affected.

Even though stock market losses have been made up, the fall in interest rates has hit annuity rates, and thus retirement incomes. So we haven't really made up the damage of 2007-08.

So the interaction between financial markets and the real economy is also in there.

The problem in 2008 was underlying economic issues much much more than any panic selling. Causation mainly flowed from economic factors to securities prices. The housing bubble burst, drastically reducing spending. We lost something on the order of $1.2 trillion of spending. Construction spending plummeted back to normal levels, reducing spending by hundreds of billions. We lost about $8 trillion of housing equity and typically people spend about 5% to 7% of this additional wealth, more hundreds of billions of private spending reductions. Government did not fill this gap. Reduced spending obviously reduces GDP and employment.

Most retirees in the US rely primarily on Social Security. Those who rely on portfolios tend to have some degree of diversification and low rates tend to support equities. The number seriously hurt by low interest rates is much less than the number helped by low rates. The level of interest rates always helps some more than others and hurt some more than others.

Interest rates are low primarily because of a weak economy. Every major country with its own currency and central bank (including those which have these as a practical matter, such as Germany) has low rates. Low rates are the effect, not a major cause (again, causation rarely is 100% in one direction).

Given that, as Alex said much earlier, we invest in bonds with negative real rates due to today's available choices.

[larryswedroe]

Browser
ST CDs (or any ST bond), or even longer ones with low early redemption fees, offer reasonable hedge against inflation but not as effective as TIPS.
Larry

[assumer]

I thought it was interesting that in that vanguard pamphlet they said only bonds but no TIPS were included during the accumulation phase of TR funds because higher inflation was protected against by better performing equities and higher salaries (and therefore presumably higher savings rates?).

[nisiprius]

Everyone must decide: how many years of past data does it take to be any sort of guide to the future? We can put some bounds on this. We know that the ten years of past data disclosed in the usual mutual fund documents--the ten-year growth chart, the 1, 5, and 10-year returns--are not enough; that's what's meant by "past performance is no sure indicator of future results." We know that fifteen years is not very good, either. Bill Miller's Legg Mason Value Trust beating the S&P every single year for fifteen years in a row, and not only did it not persist, but the crash when it came was so severe that it completely undid the gains of all fifteen preceding years.

So, more than fifteen. Probably more than twenty--as I found out in my own exploration, two matched-volatility portfolios, one with all large-company stocks and one with a mix of large and small-company stocks, had periods as long as twenty years in which large beat small by over 1%, as well as periods of twenty years the other way. Overall, the portfolio that included small-companys stocks had an 0.34% better annualized return. So, periods as long as twenty years can still fool you.

Apart from macho, seat-of-the-pants, ride-'em-cowboy watch-me-and-learn-baby intuition, the most rational investment decisions we can make are basted on the investment returns of a hypothetical portfolio over the last Y years, where Y ≥ 20. We know that they are not really a quantitative prediction, but we believe that they are some kind of decent rough actionable guide to choosing a portfolio. We believe that if portfolio A beat portfolio B over the last Y years, the chances are good that it will beat it over the next Y years as well, provided Y is long enough.

So here's the point. Having based our decision on long-term past performance, we know that we are not going to get the long-term returns of our portfolio unless we actually hold our portfolio for the long term.

A long-term strategy that is revised every couple of years is not a long-term strategy.

Now, it would be interesting to see the comparative long-term investors who invested in
a) 60% stocks, 40% bonds, and stayed the course, versus
b) Investors who constantly changed their asset allocation based on the prevailing conventional wisdom--as dispensed by the free quarterly "magazine" from their brokerage, or the cover stories of Money magazine, or some other objective measure of "the conventional wisdom."
But I don't know of any such study. Does anyone?

Tactical asset allocation funds, which were all the rage 15 or 20 years ago, adjusted stock/bond ratios according to market conditions, either by brilliant managerial insight or (in Vanguard's case) "quantitative models." The record of such funds is one of abysmal failure.

If smart managers can't do it and quantitative models can't do it, why would you or I believe we could do it?

[Browser]

Browser
ST CDs (or any ST bond), or even longer ones with low early redemption fees, offer reasonable hedge against inflation but not as effective as TIPS.
Larry

Larry - I posed another question in a different thread that I'd be interested in your opinion about. If the choice were between TIPS and I-Bonds for an investor who desires inflation protection, would it actually make sense to withdraw money from an IRA to purchase I-Bonds instead of TIPS inside the IRA? Currently, you would need to buy TIPS with 20-year maturity to receive 0% real yield to maturity and incur the term risk; whereas the I-Bond has 0% real with no term risk. Tradeoff is paying the tax on the IRA withdrawal; so maybe I-Bond with after-tax amount would be about the same as a 15-year TIP with negative real yield (guesstimate). Would this make any sense?

[Aptenodytes]

Now, it would be interesting to see the comparative long-term investors who invested in
a) 60% stocks, 40% bonds, and stayed the course, versus
b) Investors who constantly changed their asset allocation based on the prevailing conventional wisdom--as dispensed by the free quarterly "magazine" from their brokerage, or the cover stories of Money magazine, or some other objective measure of "the conventional wisdom."
But I don't know of any such study. Does anyone?

For me the studies that compare active funds to index funds constitute a suitable basis for answering your implicit question. After all, those magazine cover stories get a lot of their ideas from active managers. The aggregate behavior of active managers can be thought of as a stand-in for the "conentional wisdom," though of course there will be a very wide spread since people chase all kinds of different rainbows.

[staythecourse]

Good questions. Not sure if it was mentioned, but don't forget that it is not only inflation that makes bonds often times negative returns, but also taxes. We do not invest in a free market and capital gains is and will always be less then the taxation on fixed income to herd investors into equity markets.

The answer why folks do this is a form of frame of reference risk. Folks frame of reference is NOMINAL returns and not REAL returns. Have you ever been at dinner party and folks talk about their investments in real returns?? NEVER. That is why inflation is considered an invisible tax, because the human mind does not consider returns in real fashion.

Perfect example I have given on this site before, but folks always talk about the high rate of negative returns from stocks in any given year (around 1/3-40%), but folks would be surprised that bonds and cash also have negative return in any given year 1/3 of the time as well.

IF follks thought long term and in real returns stocks would not seem as "risky" as folks talk about.

Good luck.

[larryswedroe]

browser, I haven't done the math but I doubt that would make sense. But Ibonds certainly seem more attractive now. The problem is the very small amount you're allowed to buy
Larry

[kenyan]

Now, it would be interesting to see the comparative long-term investors who invested in
a) 60% stocks, 40% bonds, and stayed the course, versus
b) Investors who constantly changed their asset allocation based on the prevailing conventional wisdom--as dispensed by the free quarterly "magazine" from their brokerage, or the cover stories of Money magazine, or some other objective measure of "the conventional wisdom."
But I don't know of any such study. Does anyone?

I certainly haven't attempted (nor would I unless paid to do so) such a study, though it would be interesting if it could be conducted in a scientific manner. I did conduct a simple calculation a little while ago on Morningstar's "Ultimate Stock Pickers" articles. Basically, Morningstar publishes an article every quarter on the stock buying/selling actions of whom they consider to be the cream of the crop of active managers. They list the 10 best stocks (recently bought) and 10 worst stocks (recently sold) by Wall Street's best. I decided to see if that information was actionable (buying/shorting), so I compared the performance of those stocks to the broad market from the article's publication date through the quarter.

Over the most recent 5 quarters, the "buy" recommendations actually bested VTI in 3 of 5 instances, with an average outperformance of 3.2% per quarter. Unfortunately, the "sell" recommendations also bested VTI, with an average outperformance of 3.6% per quarter. Overall *alpha was negative, therefore, and the transaction/tax costs of this strategy would be prohibitive anyhow. It was interesting to note how some of their equity selections would swing from buy to sell and back again. For instance, DVN was a sell in 11/2011, a buy in 3/2012 and 6/2012, a sell in 9/2012, and a buy again in 12/2012.

*The actual managers may have done better or worse, depending upon the timing of their transactions. I was just checking whether the published information was actionable.

[Rick Ferri]

To clarify the OPs quote, all the asset classes that I invest in have had periods when the real return was negative. Treasury bills and notes are currently in that situation. This doesn't change my real return rule. I only invest in asset classes that have a long-term real return expectation (30 years), and T-notes remain one of those asset classes.

Rick Ferri

[Valuethinker]

And No. In that panic causes forced liquidation and macroeconomic effects of the horrors of 1929-1933 and 2008-09. In which point, the fundamental growth of the economy and corporate cash flow has been lowered, possibly permanently (the effects on economic output last 10+ years and on individuals for their entire careers and lives) and thus all investors are affected.

Even though stock market losses have been made up, the fall in interest rates has hit annuity rates, and thus retirement incomes. So we haven't really made up the damage of 2007-08.

So the interaction between financial markets and the real economy is also in there.

The problem in 2008 was underlying economic issues much much more than any panic selling. Causation mainly flowed from economic factors to securities prices. The housing bubble burst, drastically reducing spending. We lost something on the order of $1.2 trillion of spending. Construction spending plummeted back to normal levels, reducing spending by hundreds of billions. We lost about $8 trillion of housing equity and typically people spend about 5% to 7% of this additional wealth, more hundreds of billions of private spending reductions. Government did not fill this gap. Reduced spending obviously reduces GDP and employment.

Most retirees in the US rely primarily on Social Security. Those who rely on portfolios tend to have some degree of diversification and low rates tend to support equities. The number seriously hurt by low interest rates is much less than the number helped by low rates. The level of interest rates always helps some more than others and hurt some more than others.

Interest rates are low primarily because of a weak economy. Every major country with its own currency and central bank (including those which have these as a practical matter, such as Germany) has low rates. Low rates are the effect, not a major cause (again, causation rarely is 100% in one direction).

Given that, as Alex said much earlier, we invest in bonds with negative real rates due to today's available choices.

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).

[grayfox]

To quote Rick Ferri: "Securities that only keep pace with inflation are not suitable for a long-term investor" (All About Asset Allocation, p.94). This is the main reason why Rick does not recommend e.g. commodities as an asset class.

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.

Being an investment adviser, I find that many, if not most, investors have a hard time realizing just how poor the expected return from bonds is. Intellectually, investors understand it, but they don't feel it - yet.

Merry Christmas!

Jesper

First of all, it is the whole portfolio that matters.

Now what has happened is that interest rates on all bonds have come down, while the risks haven't really changed. For example, in 2007 PenFed 5-year CDs were yielding 6%. That was 6% nominal return without risk. Well, there was inflation risk. Today the yield is only 1.8%. Bond yields have shifted down about 4%. As you point, out some fixed income now offer negative return after inflation.

But like I said, it's the whole portfolio. So do bonds with negative real yields still have a place in the portfolio?

I am trying to be objective about it, so I am only basing my answer on computations. I set up a portfolio optimization problem. I included U.S. stock ETFs, foreign stock ETFs and bond ETFs. Also GLD and Roulette Bets. The bond ETFs were ST, IT, LT Treasuries and investment-grade corporate bonds. Also bond index and total bond market. Assuming 2% inflation, all the Treasuries have negative real YTM. Total bond also. The ST corporate also has negative real yield, but the IT and LT corporates have positive real yield. GLD also had negative expected real return. And of course the Roulette bets had negative expected return.

I picked a standard deviation and had it find maximum return.

Result -> The optimizer allocates zero to the bond ETFs with negative expected real return. It prefers bond ETFs that have a positive expected return. GLD was also left out of the optimum portfolio. Not surprisingly there was no allocation to Roulette bets.

My conclusion is that, if you are trying to build a portfolio with maximum return at some level of risk, adding negative returning assets usually doesn't help, even if they are uncorrelated with stocks, as are Roulette bets.

[tadamsmar]

To quote Rick Ferri: "Securities that only keep pace with inflation are not suitable for a long-term investor" (All About Asset Allocation, p.94). This is the main reason why Rick does not recommend e.g. commodities as an asset class.

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.

Being an investment adviser, I find that many, if not most, investors have a hard time realizing just how poor the expected return from bonds is. Intellectually, investors understand it, but they don't feel it - yet.

Merry Christmas!

Jesper

I find it interesting that no one has pointed the basic error in your post. You conflate real return with yield to maturity for a bond fund. Return is the difference between the ask and bid at two different times. I guess we just take it for granted that return will be negative for some unspecified future period. But, bond funds can still hold up well in possible scenarios where stocks do poorly.

[stan1]

I think there are plenty of people who have been relying on bonds to both reduce volatility/risk and provide return. A few people made that decision decades ago, and a lot of people have made that decision in the past 3 years. The assumption that bonds will reduce risk AND provide return is baked into decisions on asset allocation (equity vs fixed income). If the assumption that bonds will contribute a positive return to a portfolio is no longer valid, there are some people who probably need to review their asset allocation decision to make sure they aren't relying on bonds to yield a return. Examples of people who probably need to do this are people in their 50s-60s with long life expectancies who have greater than 40% allocations to bonds.

[tadamsmar]

BLV has a 0.5% return since the open today. That a nice big positive real return.

[dratkinson]

To quote Rick Ferri: "Securities that only keep pace with inflation are not suitable for a long-term investor" (All About Asset Allocation, p.94). This is the main reason why Rick does not recommend e.g. commodities as an asset class.

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.

Being an investment adviser, I find that many, if not most, investors have a hard time realizing just how poor the expected return from bonds is. Intellectually, investors understand it, but they don't feel it - yet.

Merry Christmas!

Jesper

As a novice investor, this topic has progressed as I expected and with the expected outcome: bonds are a necessary component of any portfolio, choose your flavor and stay the course. Period---actions steps straight out of the academic literature.

However, what I did not expect was that it would begin with a question asked by a trained investment adviser.

IMO it is the primary responsibility of an investment adviser to know this stuff (the two major asset classes are equities and bonds, bonds reduce portfolio risk, total bond return is composed of more than yield, the high returns earned by '80s bond holders only accrued to those who held bonds before the '80s,...) and to hold the hands of nervous investors by explaining this stuff to them. A worthwhile investment adviser must have the academic investing background necessary to remain steadfast when clients panic. It is the only reason an investment adviser can justify his pay.

I almost thought OP was looking to the BHs to provide justification to support a short-term tactical repositioning (to justify his fee) that would allow him to move his clients from bonds into equities "to better keep up with inflation", in a *sell-low buy-high reach for increased return.

*As bonds seem to be lower now and equities seem to be higher, this must result in a losing position and increased risk for his clients.

I am really surprised knowing this academic investing history as a novice investor and it needing to be explained to a *trained investment adviser "wanting to challenge himself". It does not instill confidence.

*I once refused an interview with a prospective investment adviser when it became obvious that I knew more about investing than she. Don't know how she got my number.

Bottom line. If the senior BHs must explain this to a trained investment adviser, then the training was insufficient. May I recommend OP read some of the BH-recommended books. It will give him the investing background missing from his training and the confidence to *stay the course for his clients.

*Assuming he is allowed to do so and not working at a client churn-and-burn investing firm.

Apologies if I've given offense as none was intended.

[Browser]

browser, I haven't done the math but I doubt that would make sense. But Ibonds certainly seem more attractive now. The problem is the very small amount you're allowed to buy
Larry

I agree that amounts are small. Even so, I'm contemplating a $10K distribution from my IRA to buy some more I-Bonds. Just don't want to purchase any more TIPS at negative or low real yields and take on the term risk, and have the $10K sitting in cash right now. We seek small acorns wherever they can be found these days.

[jjustice]

An odd picture seems to be developing on this thread. Bonds (perhaps only US government bonds? ) are unique: they constitute the one asset class that can never be too expensive to buy.

John

[hazlitt777]

To quote Rick Ferri: "Securities that only keep pace with inflation are not suitable for a long-term investor" (All About Asset Allocation, p.94). This is the main reason why Rick does not recommend e.g. commodities as an asset class.

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.

Being an investment adviser, I find that many, if not most, investors have a hard time realizing just how poor the expected return from bonds is. Intellectually, investors understand it, but they don't feel it - yet.

Merry Christmas!

Jesper

It is unfortunate that we have been forced to accept a bond investing environment in which rates are likely to be negative in real turns.

However, to have a diversified portfolio, one needs stocks, bonds...and I would add gold(a nice simple proxy for all commodities IMO), to protect one from short term to intermediate term volatility in each of these particular asset classes.

Remember, stocks short and intermediate term can really hurt you. So, going without bonds which can depreciate slowly to be all in stocks which can depreciate quickly is not wise. (Or all in bonds which could depreciate quickly while stocks and gold would in such a scenario hopefully provide relative stability.)

[grayfox]

I think there are plenty of people who have been relying on bonds to both reduce volatility/risk and provide return. A few people made that decision decades ago, and a lot of people have made that decision in the past 3 years. The assumption that bonds will reduce risk AND provide return is baked into decisions on asset allocation (equity vs fixed income). If the assumption that bonds will contribute a positive return to a portfolio is no longer valid, there are some people who probably need to review their asset allocation decision to make sure they aren't relying on bonds to yield a return. Examples of people who probably need to do this are people in their 50s-60s with long life expectancies who have greater than 40% allocations to bonds.

Excellent point.

If you open up some pop investment books, you'll read that stocks return 10% and bonds return 5%, as if those numbers are carved in stone for all eternity. If the advice in the book is based on those returns, how good is the advice?

[hazlitt777]

An odd picture seems to be developing on this thread. Bonds (perhaps only US government bonds? ) are unique: they constitute the one asset class that can never be too expensive to buy.

John

If you mean that bonds are the only asset that can not be in a bubble, I would disagree. Any asset can be in a bubble. I hope that isn't the premise of the discussion behind this thread.

Practically speaking, IMO, one shouldn't speak so much of whether a financial asset class is "too expensive to buy." Since we can't time when a bubble will pop, it is best long term not to market time, and just stay diversified between the three major financial asset classes: stocks, bonds and gold (a nice simple proxy for all commodities); no matter what your opinion may be about which may be in a bubble.

[hazlitt777]

I think there are plenty of people who have been relying on bonds to both reduce volatility/risk and provide return. A few people made that decision decades ago, and a lot of people have made that decision in the past 3 years. The assumption that bonds will reduce risk AND provide return is baked into decisions on asset allocation (equity vs fixed income). If the assumption that bonds will contribute a positive return to a portfolio is no longer valid, there are some people who probably need to review their asset allocation decision to make sure they aren't relying on bonds to yield a return. Examples of people who probably need to do this are people in their 50s-60s with long life expectancies who have greater than 40% allocations to bonds.

Excellent point.

If you open up some pop investment books, you'll read that stocks return 10% and bonds return 5%, as if those numbers are carved in stone for all eternity. If the advice in the book is based on those returns, how good is the advice?

I agree. Excellent point. In another place, I asked whether one shouldn't at least "tweek" their allocation a bit more toward stocks to offset the loss of real return potential in bonds. But I wouldn't get rid of bonds all together because that puts one at risk in regard to the damage stocks can suddenly do to ones net worth.

[hoops777]

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?

[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?

Ok you have to think beyond D Day, whence you retire. Because you have to have a plan post retirement, unless you are going to fully annuitize.

The data suggests there is an anomaly: ST Investment Grade corporate bonds do a bit better than guvvies, so the credit risk is not paid for in higher default rate (not true of all IG bonds, just ST ones).

You have higher coupons, generally, so marginally lower convexity and duration (less sensitivity to interest rate changes).

In this environment, unfortunately truly blue chip corporates are borrowing at US Treasury yields (or even below?). You do wind up with for example bonds issued by banks and insurers that are 'investment grade' but the market puts them on a higher yield than other IG bonds-- reflecting the risk of another Lehman or Euro-crash.

You could take money out of stock funds and put it into IG bonds-- either funds, or individual names. However you'll have higher volatility (than US Treasuries) and you have limited liquidity. Some pretty big IG names (Nortel, Enron, Worldcom, GM) were IG within a couple of years of default. You have to avoid bonds with call provisions. Just look at Intel-- they are on the wrong side of the glidepath of history, and it's not at all clear they can pick up-- tablets are besting PCs, and it could be in 10 years we just don't use PCs, we use the Cloud accessed by tablets and smartphones. GE? Huge financial services operation. Lots that can go wrong (I don't think it will, but it could).

I'd look at US municipals in this context: Larry Swedroe has written good stuff on this market. After tax you might wind up in similar situations.

If there are CLO funds floating about, then it might be interesting (although the MERs are likely to be high).

I guess my conclusion is that it probably wouldn't hurt to have money in IG ST bond funds, but the yield pickup is small over US Treasuries.

[Browser]

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.

[Jesper Dall]

to grayfox and stan1:

I agree. I live and work in Denmark, where investors are a lot more "bond fond" than most of you living on the other side of the pond (for no valid reason IMO): The great majority of investors in their 50s and 60s have more than 60% bonds in their portfolios.

Obviously, we cannot exclude bills/bonds entirely from our portfolios, even when they have reached a level of expected return so low that it is fair to refer to them as "return-free risk".

My question is: Can expected bond returns ever become so low (or high for that matter) that we are willing to adjust our overall asset allocation plan? In other words, can it ever challenge our "stay the course" tenet?

I think this is a very legitimate question, even to seasoned Bogleheads, given the historically low interest rates (I am aware that this forum is not at alphaheads.org )

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"...

Jesper Dall