Which bond asset class best protects against stock market crash?

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GrowthSeeker
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Which bond asset class best protects against stock market crash?

Post by GrowthSeeker » Thu Aug 09, 2018 1:28 pm

By "crash" I mean either a severe drop of, say, 35-50% in stock indices with prolonged recovery, or a bear market. By "protects" I mean protects the value of your total net worth when the stock component drops.

One of the things I've learned on this forum, is that answers to such questions may strongly depend on one's overall goals and long term financial strategy, investment plan, asset allocation and so forth.

Therefore, to narrow the discussion, let's make some assumptions about our investor:
- is near the onset of retirement
- has an AA of 60/40 (stocks/bonds)
- planning a "bond tent".
- goal is to mitigate against Sequence of Return Risk


Let's eliminate cash and money market funds which we know are not too bad, but lose value due to inflation.
Let's also eliminate corporate bonds since this asset class is somewhat correlated with stocks.
Thus the time frame of the "idea" is the expected duration of stock market doldrums (which historically can vary from a few months to a few decades). Or maybe the time frame is the duration that the sequence of returns risk is greatest (decade before and decade after retirement).

So this leaves individual Treasury bills/notes or CDs of different durations; and different bond funds of different durations but which are either mostly or totally based on Treasuries.

So what's a bond investor to do? How is one to make a strategy given the above ideas / goals / constraints?

Discussion: The years just before and after retirement are said to be a time most susceptible to "sequence of returns risk"; and a time during which some advocate for a "bond tent" (i.e. the percent bonds in the portfolio goes up during the decade before retirement and then goes down over the first decade of retirement so the graph resembles a shark's dorsal fin, or a "tent").

According to Dr. ERN of earlyretirementnow.com, 10-year bonds were most protective during the market downturns of 1929 and 2000, but short duration bonds (e.g. 3 month T-bills) performed better during the 1970s.

And I think we know that the various bond asset classes will respond differently depending on the cause of the market crash. But just as we cannot predict the next market crash, I assume we also cannot predict the cause of the next crash.

References:
Sequence of Return Risk: https://www.kitces.com/blog/understandi ... -decades/
Bond tent: https://www.kitces.com/blog/managing-p ... ed-zone/
Just because you're paranoid doesn't mean they're NOT out to get you.

balbrec2
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Re: Which bond asset class best protects against stock market crash?

Post by balbrec2 » Thu Aug 09, 2018 2:08 pm

60/40 AA is a poor one for someone trying to utilize a bond tent unless they
desire to end up at 80/20 or higher. I would fully expect someone wishing to utilize a bond tent strategy
to be more along the lines of 40/60 or even 30/70 AA, just prior to retirement. An intermediate Treasury
fund is all you need for a bond allocation. Especially since no one can predict the future.
Just my $.02

gmaynardkrebs
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Re: Which bond asset class best protects against stock market crash?

Post by gmaynardkrebs » Thu Aug 09, 2018 2:35 pm

Not that Monte Carlo sims are gospel, but they would be a good place to start on a question like yours. Just be sure to use your own inputs A lot of the ones I've tried have unrealistic default inputs for historic returns.

WhiteMaxima
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Re: Which bond asset class best protects against stock market crash?

Post by WhiteMaxima » Thu Aug 09, 2018 3:01 pm

I would choose FDIC insured CD above any bond against stock market crash. Bond holder will be next to stock holder to see their value crash.

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aj76er
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Re: Which bond asset class best protects against stock market crash?

Post by aj76er » Thu Aug 09, 2018 3:18 pm

Paul Merriman suggests the following for one's bond allocation:

50% intermediate term treasuries
30% short term treasuries
20% TIPS

Alternatively, you could explore the use of international bond funds, but the currency hedging tends to make them behave similar to a domestic bond fund.

A total market bond fund is a pretty good default position. It won't have quite as much pop in a deflationary crisis, but you'll get a bit more yield overall.
"Buy-and-hold, long-term, all-market-index strategies, implemented at rock-bottom cost, are the surest of all routes to the accumulation of wealth" - John C. Bogle

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Doc
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Re: Which bond asset class best protects against stock market crash?

Post by Doc » Thu Aug 09, 2018 3:46 pm

The term "bond tent" is not in my vocabulary so let me try to work around it.
GrowthSeeker wrote:
Thu Aug 09, 2018 1:28 pm
Therefore, to narrow the discussion, let's make some assumptions about our investor:
- is near the onset of retirement
- has an AA of 60/40 (stocks/bonds)
- planning a "bond tent".
- goal is to mitigate against Sequence of Return Risk
Let's try an example:

Total portfolio value: $100
AA = 60/40
Stock market declines by 50%
-
I now have $30 in stock and $40 in bonds for a total of $70.
In order to rebalnce back to 60/40 I need to get my equity up to $70*.6 = $42k
I need to sell $12k of the bonds and buy $12k of stocks.
-
That $12k in bonds should be in Treasuries which is probably the only FI class that is likely to go UP in a stock market crash.
After I rebalance I now have only $28k in FI and maybe I need that to meet expenses until everything gets back to "normal". (Is this $28k my tent?)
That $28k should be in more Treasuries plus investment grade FI.
-
Given this scenario I would have my original $40k in bonds split equally between Treasures and investment grade corporates.
I've already taken care of the equity collapse so now over the next few years I will build my bond portfolio back to a 50:50 mix of Treasuries and corporates as the markets recover.
-
The simplest way to accomplish this is to have my original FI portfolio split evenly into a 1-10 year Treasury fund/ETF/ladder and a 1-10 investment grade fund/ETF. Depending on personal issues you might need more than two positions to optimize the tax considerations. Since I am now retired I don't want to take any more risk than I need to so I should not use long bonds. But I may have to take on some risk to meet my cash flow requirements so that's why I have some investment grade FI. I don't need to have any extra extra risk free assets like more Treasuries or CD's

Run your own numbers. :beer
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.

gmaynardkrebs
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Re: Which bond asset class best protects against stock market crash?

Post by gmaynardkrebs » Thu Aug 09, 2018 4:17 pm

Doc wrote:
Thu Aug 09, 2018 3:46 pm
... as the markets recover.
ahem...

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Doc
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Re: Which bond asset class best protects against stock market crash?

Post by Doc » Thu Aug 09, 2018 4:33 pm

gmaynardkrebs wrote:
Thu Aug 09, 2018 4:17 pm
Doc wrote:
Thu Aug 09, 2018 3:46 pm
... as the markets recover.
ahem...
The bond markets. I've already taken care of the equity rebalncing now I only need to get the FI back to the desired Treasury/Corporate mix. And that should be a given after the "duration".

If you don't want to wait that long use a 1-5 funds instead of a 1-10.
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.

gmaynardkrebs
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Re: Which bond asset class best protects against stock market crash?

Post by gmaynardkrebs » Thu Aug 09, 2018 4:54 pm

Doc wrote:
Thu Aug 09, 2018 4:33 pm
gmaynardkrebs wrote:
Thu Aug 09, 2018 4:17 pm
Doc wrote:
Thu Aug 09, 2018 3:46 pm
... as the markets recover.
ahem...
The bond markets. I've already taken care of the equity rebalncing now I only need to get the FI back to the desired Treasury/Corporate mix. And that should be a given after the "duration".

If you don't want to wait that long use a 1-5 funds instead of a 1-10.
The "ahem" refers to the fact that you assume as a given that the market will recover. That is a heroic assumption that assumes away the greatest risk of holding equities in retirement accounts. It is one that I personally would not apply to anyone who posed the question asked by the OP, unless he stated he has already secured himself a secure retirement through SS, an inflation adjusted pension, or a TIPS LMP.

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Doc
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Re: Which bond asset class best protects against stock market crash?

Post by Doc » Thu Aug 09, 2018 6:57 pm

gmaynardkrebs wrote:
Thu Aug 09, 2018 4:54 pm
The "ahem" refers to the fact that you assume as a given that the market will recover.
I got that. I was addressing the bond market. And those bonds will mature. So you will get your money back at about the length of time as the duration of your bonds or maybe sooner.

The time it takes for the stock market to recover is unknown. That's one of the reasons we hold bonds. With bonds we at least have income while the stock market does whatever it does.

If the stock market recovery takes longer than you think it will then your 60/40 AA was too optimistic. But the 60/40 was specified by the OP's question.
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.

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