Merriman: Why bonds are the most important asset class

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Rx 4 investing
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Merriman: Why bonds are the most important asset class

Post by Rx 4 investing » Sun Jun 14, 2015 9:59 am

In his latest article over at MarketWatch, "retirementor" Paul Merriman offers some timely advice on the role of bonds in a portfolio, esp. given all the recent noise and confusion surrounding a possible Fed short-term rate hike:

"Actually, it makes very little sense right now to buy or own bonds in the hope that you'll be able to sell them later at a higher price. And that's exactly the problem that gets investors into trouble. They think that if you can't sell an investment at a profit, that investment is a bum deal. However, the truth is this: Making a profit isn't why you should own bonds. "

His counsel: "When the market goes into a serious decline, many investors panic and wish for safety. That safety is easily at hand, in the form of bond funds. If you have the right percentage of your portfolio in bonds, you're much more likely to stay the course. And if you stay the course, you're much more likely to be in the market when it's going up."

(Reading time 2 minutes). http://www.marketwatch.com/story/why-bo ... -10?page=1

Simple, but elegant. I think Mr. Bogle would approve of Paul's message. Cheers! :beer
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Re: Merriman: Why bonds are the most important asset class

Post by Call_Me_Op » Sun Jun 14, 2015 10:17 am

I listened to that podcast (same title as the article but more detail)- and it was OK. I think he could have touched-on bond-fund alternatives such as bank CD's and Savings Bonds - to complete the picture. He discussed duration (as a risk factor) but failed to identify the fixed-income instruments that effectively have zero duration. I'd like to see him discuss fixed-income in greater detail. He calls bonds "the most important asset class" but devotes 100X more air time to equities.

Above said, Paul is a good guy and enjoy all of his material.
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Re: Merriman: Why bonds are the most important asset class

Post by nedsaid » Sun Jun 14, 2015 10:28 am

We experienced the golden age of investing from 1982 through early 2000, in 1982 interest rates were very high and stocks and bonds both cheap. Not only did stocks and bonds have no where to go but up, we had an economic boom from 1984 through 2007. During most of those years, even cash generated pretty decent returns. It indeed was investing nirvana. If you extend the "nirvana" period out to today's date from 1982 on, the returns of both stocks and bonds look splendid. Stocks recovered nicely from the two bear markets of the 2000's.

Now we seem to be at the inverse of that, interest rates are very low and both stocks and bonds are relatively expensive. The economy isn't doing badly but economic growth has been subdued since the 2008-2009 financial crisis. The assumptions that we had about both stocks and bonds might need some rethinking. Cash pays almost nothing and is losing purchasing power.

During the golden age of investing that I described, I thought of stocks as the most important asset class. After the twin bear markets of 2000-2002 and of 2008-2009, I grew to appreciate bonds a whole lot more.

I still believe that bonds are an important cushion to stock market volatility, the cushioning effect will be considerably less than before because very low interest rates generate very little income. The regular income has a cushioning effect. Also, rates have less room to fall during a recession so the potential for resulting capital appreciation is very limited.

We also should be mindful that the future expected returns of both stocks and bonds will be lower than what we experienced during the period of investing nirvana. We need to adjust our expectations.
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Re: Merriman: Why bonds are the most important asset class

Post by Rx 4 investing » Sun Jun 14, 2015 10:41 am

FYIs...

This passage is from Merriman's rationale describing his "Ultimate Buy and Hold Strategy" (for tax-deferred accounts):

"Whether your portfolio is heavy or light on bonds, what matters is the kind of bonds you own. In general, longer bond maturities go together with higher yields and higher volatility (higher standard deviation, in other words). However, as you extend maturities beyond intermediate-term bonds, the added volatility (risk) rises much faster than the additional return.

My recommended tax-deferred bond portfolio is exclusively in government bond funds. The bond portfolio in this article, is comprised of 50% intermediate-term funds, 30% short-term funds and 20% in TIPS funds for inflation protection. (TIPS funds invest in U.S. Treasury inflation-protected securities, which automatically adjust their values and interest payments to changes in the Consumer Price Index.)

It’s important to get the bond part of this strategy right. Why do I exclude corporate bond funds? In a nutshell, corporate bond funds entail some risk of default – a risk that tends to increase at the very times we most want stability. I believe in taking calculated risks on the stock side of the portfolio and being very conservative on the bond side. U.S. Treasury and government securities have historically been very safe."

His recommended Vanguard bond funds
(see tables at the link for allocation suggestions based on "aggressive", "moderate" or "conservative")...

http://paulmerriman.com/vanguard/

For tax deferred accounts, he recommends...

--Vanguard Short‐Term Treasury VFISX
--Vanguard Interm‐Term Treasury VFITX
--Vanguard Inflation‐Protected Secs VIPSX

For taxable portfolios, he recommends...

--Vanguard Intermediate Term US Treasuries VFITX
--Vanguard Limited Duration Tax-Exempt VMLTX
--Vanguard Intermediate Term Tax-Exempt VWITX

For emergency fund portfolios, he recommends...

--Vanguard Prime Money Market VMMXX
--Vanguard Short Term Investment Grade VFSTX

For a monthly income portfolio, he recommends...

--Vanguard Short‐Term Investment‐Grade VFSTX
--Vanguard Interm‐Term Invmt‐Grade VFICX
--Vanguard GNMA VFIIX
--Vanguard High‐Yield Corporate VWEHX

Hope these provides some additional details. :happy
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Re: Merriman: Why bonds are the most important asset class

Post by nisiprius » Sun Jun 14, 2015 11:26 am

Paul Merriman, quoted by Rx 4 investing wrote:...Actually, it makes very little sense right now to buy or own bonds in the hope that you'll be able to sell them later at a higher price. And that's exactly the problem that gets investors into trouble. They think that if you can't sell an investment at a profit, that investment is a bum deal. However, the truth is this: Making a profit isn't why you should own bonds...
Sure. I think this is the core of the confusion about bonds.

In the case of an investment-grade bond, selling the bond for more than you bought it = speculation, receiving and perhaps reinvesting the interest payments = investing.

If you ignore the interest payments, then bonds always look like a bum deal. The price of Vanguard Total Bond Index Fund was $10/share at inception in 1986, and it's $10.85 now. That works out to capital appreciation of 0.3% per year. Notice, too, that the so-called "thirty-year bull market in bonds" is hardly evident.

If you are trying to make money off bonds by buying at one price and selling at a higher price, your only chance is to time the market fluctuations. My guess is that a lot of the handwringing about "bonds being riskier than stocks right now," as well as descriptions like the "bond massacre" of 1994, are coming from bond "traders" who are trying to do precisely that.

Source: Morningstar

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Re: Merriman: Why bonds are the most important asset class

Post by watchnerd » Sun Jun 14, 2015 12:19 pm

nedsaid wrote: I still believe that bonds are an important cushion to stock market volatility, the cushioning effect will be considerably less than before because very low interest rates generate very little income. The regular income has a cushioning effect. Also, rates have less room to fall during a recession so the potential for resulting capital appreciation is very limited.
The negative correlation of treasuries to stocks persists across many years across and wide range of interest rate environments. In other words, the cushioning effect isn't entirely dependent upon low vs high income.
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Re: Merriman: Why bonds are the most important asset class

Post by hafius500 » Mon Jun 15, 2015 1:34 pm

Paul Merriman wrote:
In the 45 calendar years from 1970 through 2014, the worst years for the diversified all-equity portfolio were 1974 (a loss of 22.6%) and 2008 (a loss of 41.7%). In 1974, bonds were up 6.5%. In 2008, they were up 7.1%.
But why would a "rational" investor with a time horizon of more than one year care about one-year returns?

Jim O'Shaughnessy (What Works On Wall Street) - Hey 54-year-old boomers, stocks are still the best thing to hold until you turn 65.
Between 1926 and 2014, here are the average, inflation-adjusted gains for four asset classes:
...
the worst 11-year returns for each of the four asset classes:

*S&P 500: inflation-adjusted worst cumulative 11-year return is -36 percent, with $10,000 falling to $6,400.
...
*U.S. Intermediate-term Treasury bond: inflation-adjusted worst cumulative 11-year return is -37 percent, with $10,000 falling to $6,300.

*U.S. T-bills: inflation-adjusted worst cumulative 11-year return is -43 percent, with $10,000 falling to $5,700.
...
The next thing you need to consider are the odds of negative returns for each asset class over the next 11 years. Between 1926 and 2014, here’s the percentage of the times each asset class provided inflation-adjusted 11-year losses (of any magnitude):

*S&P 500: 17 percent of all rolling 11-year holding periods.
...
*U.S. Intermediate-term Treasury bond: 29 percent of all rolling 11-year holding periods.

*U.S. T-bills: 38 percent of all rolling 11-year holding periods.
Thus, how do you weight short-term benefits (?) versus long-term risks (if you believe that these back-testings predict the future)?

The passive investor holds the market portfolio of risky assets (i.e., stocks and bonds) if his or her risk aversion is not different from the risk aversion of the average representative investor.
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Re: Merriman: Why bonds are the most important asset class

Post by nisiprius » Mon Jun 15, 2015 1:41 pm

watchnerd wrote:
nedsaid wrote: I still believe that bonds are an important cushion to stock market volatility, the cushioning effect will be considerably less than before because very low interest rates generate very little income. The regular income has a cushioning effect. Also, rates have less room to fall during a recession so the potential for resulting capital appreciation is very limited.
The negative correlation of treasuries to stocks persists across many years across and wide range of interest rate environments. In other words, the cushioning effect isn't entirely dependent upon low vs high income.
There is no "negative" correlation between treasuries and stocks. The correlation between treasuries and stocks is close to zero. It is not negative. SBBI data from 1926 through 2009 show the correlation of real returns between "large-company stocks" (S&P 500 and predecessors) to have been:

+0.23 for long-term corporate bonds
+0.11 for long-term government bonds
+0.08 for intermediate-term government bonds
+0.10 for Treasury bills.

I'm sure that none of those are significantly different from zero (although nobody ever seems to state confidence limits on financial statistics), but not one of them is negative.
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Re: Merriman: Why bonds are the most important asset class

Post by watchnerd » Mon Jun 15, 2015 2:03 pm

nisiprius wrote:There is no "negative" correlation between treasuries and stocks.
This data indicates that it can be negative -- there is a negative average correlation between stock funds and treasury funds during the timeframe indicated (1992 - 2015, which covers the available data for these two funds) and that the correlation has been mostly negative for the last ~15 years.

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Re: Merriman: Why bonds are the most important asset class

Post by kolea » Mon Jun 15, 2015 2:34 pm

nedsaid wrote:
We also should be mindful that the future expected returns of both stocks and bonds will be lower than what we experienced during the period of investing nirvana. We need to adjust our expectations.
I guess we all see things differently. What I see is that the real total return over the last 15 years has been 1.9% (geometric) for equities. Despite the raging bull the last few years we are still way below the historic average of about 7% real return (depends on where you start from). I was thinking that we still have a lot of catching up to do! :)
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Re: Merriman: Why bonds are the most important asset class

Post by nedsaid » Mon Jun 15, 2015 9:28 pm

TwoByFour wrote:
nedsaid wrote:
We also should be mindful that the future expected returns of both stocks and bonds will be lower than what we experienced during the period of investing nirvana. We need to adjust our expectations.
I guess we all see things differently. What I see is that the real total return over the last 15 years has been 1.9% (geometric) for equities. Despite the raging bull the last few years we are still way below the historic average of about 7% real return (depends on where you start from). I was thinking that we still have a lot of catching up to do! :)
The US Stock Market was pretty much flat from early 2000 until maybe 2012 with two large bear markets in between. We saw the flip side of the 1990's where we saw Price/Earnings ratio expansion. Earnings grew during the 2000's but P/E ratios shrank. Shrinking P/E's are a big drag on returns.
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