Bonds and their role in a portfolio:

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Nowizard
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Bonds and their role in a portfolio:

Post by Nowizard » Sat Nov 17, 2018 8:43 am

Bonds provide diversification and downside protection, as we all learn early on in our investment days. Their role in a portfolio is almost always conceptualized as ballast and risk deterrence. Most here who use funds recommend the Vanguard Total Bond Index. However, another view is that the Total Bond Index, provides an anchor rather than a stabilizing ballast during positive markets in the sense of returns. Other bond funds have provided higher returns in exchange for greater risk, as they should.
Some here want risk protection who are willing to accept greater risk than others. Typically, discussions revolve about having a higher allotment to equities in such cases. Is there any reason to consider staying with the same stock/bond ratio but with riskier bond choices in an effort to obtain higher returns or are the data conclusive in regard to the Total Bond Index always being the better choice over time? In short, if riskier bond funds perform more like equities in terms of returns and volatility, can they ever be a better choice than increasing equity allotments for that portion of a portfolio, as counter intuitive as it sounds?


Tim

longinvest
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Re: Bonds and their role in a portfolio:

Post by longinvest » Sat Nov 17, 2018 9:43 am

There are two main approaches to increase risk in a bond allocation:
  • Invest into lower quality bonds (e.g. junk bonds which are sometimes called high-yield bonds).
  • Increase the average maturity of the bond portfolio (e.g. concentrate the investment into long-term bonds).
Junk bonds can default and tend to do so in times of economic distress, when stocks are often down. Long-term bonds are quite volatile. While they often carry a higher yield than intermediate-term bonds, the yield differential is often quite small.

Beyond the higher volatility risk of long-term bonds, there are other risks. In a rising yield environment, long-term bonds can underperform Treasury bills for a long time. They underperformed for 20 years, in Canada, when yields started to increase in the 1970s. It can be mistake to hope for higher returns in the short term.

Many members of this site like to have little volatility in their bond allocation; they prefer to take volatility risk in their stock allocation. Note that the total bond market does include an allocation to long-term bonds, but their risks are dampened by a higher allocation to bonds of shorter maturities.

A few members invest into bonds primarily to diversify their portfolio holdings, not to dampen stock volatility. Some of them do concentrate their bond allocation into long-term bonds, but they might include inflation-indexed bonds to dampen the inflation risk of nominal bonds.

Note the key word, here: diversification, as in not putting all of one's eggs into the same basket. This usually lowers long-term returns. It's usually more rewarding to be fully invested into the best performing asset!

One should be wary of any claim that diversification into some special asset increases returns due to some magical rebalancing bonus; it's usually the talk of someone who will profit directly or indirectly from the special investment.
Last edited by longinvest on Sat Nov 17, 2018 11:38 am, edited 2 times in total.
Bogleheads investment philosophy | Lifelong Portfolio: 25% each of (domestic / international) stocks / domestic (nominal / inflation-indexed) long-term bonds | VCN/VXC/VLB/ZRR

PFInterest
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Re: Bonds and their role in a portfolio:

Post by PFInterest » Sat Nov 17, 2018 9:44 am

im sure there are scenarios.

but why not take your risk on the equity side?

Nowizard
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Re: Bonds and their role in a portfolio:

Post by Nowizard » Sat Nov 17, 2018 10:13 am

Risk on the equity side is definitely the most common approach. Question posed since I had not seen a discussion of this approach, assumed it was one that was discounted but wanted to see if others had comments.

Tim

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Sandtrap
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Re: Bonds and their role in a portfolio:

Post by Sandtrap » Sat Nov 17, 2018 11:10 am

Nowizard wrote: ā†‘
Sat Nov 17, 2018 8:43 am
1.
Is there any reason to consider staying with the same stock/bond ratio but with riskier bond choices in an effort to obtain higher returns or are the data conclusive in regard to the Total Bond Index always being the better choice over time?
2.
In short, if riskier bond funds perform more like equities in terms of returns and volatility, can they ever be a better choice than increasing equity allotments for that portion of a portfolio, as counter intuitive as it sounds?
1
Yes . . . and no.
2
Depending on the proportion of diversification of the "fixed" percentage of assets. IE: CD ladders, Treasuries, Muni's, etc. as an "anchor" to the Bond Fund percentage of the entire portfolio.

Does this make sense?
j

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nisiprius
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Re: Bonds and their role in a portfolio:

Post by nisiprius » Sat Nov 17, 2018 11:20 am

It's really something personal that you need to explore for yourself. I agree with "take your risk on the equity side."

Junk bonds ("high-yield") have risk that's been reliably correlated with stocks, which makes sense because junk bonds are less isolated from the business performance of the issuer; so they're just "somewhat stock-like bonds" and I've never seen any evidence that they do anything special for you that couldn't be done just as well by slightly increasing stock allocation.

Although in my opinion the size and importance of the effect are often wildly exaggerated, bonds tend to move independently of stocks. (Independently, not not not in the opposite direction). Because of this, the total "risk," as measured by standard deviation, in a portfolio that includes both stocks and bonds, is slightly lower than the weighted average of the individual risks, and thus there is a slight improvement in the risk-adjusted return. This effect is stronger if the bonds are more volatile, and the longer the term the higher the volatility. Therefore, people whose rationale for including bonds is based on "modern portfolio theory" and "low correlation" will get more of what they want from long-term bonds. I wouldn't touch a pure long-term bond fund myself because I lived through the 1970s and therefore have an (exaggerated?) fear of inflation risk. Long-term TIPS, maybe.
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whodidntante
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Re: Bonds and their role in a portfolio:

Post by whodidntante » Sat Nov 17, 2018 11:32 am

To each his or her own. If you want to take risk in fixed income, here are some ways that might be sensible:
- Buy fallen angels (bonds that recently got downgraded to non-investment grade credit quality) since these have outperformed dusty junk.
- Use treasury futures to gain cheap leverage, and the term risk you desire.
- Buy carefully selected distressed assets like a hedge fund, e.g. defaulted bonds.
- Buy risk transfer assets, like catastrophe bonds or reinsurance. Hedge funds and institutional investors have been doing this for years.
- Buy high yield foreign sovereign bonds.
- Carry trade.

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prudent
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Re: Bonds and their role in a portfolio:

Post by prudent » Sat Nov 17, 2018 12:45 pm

Topic moved to Investing - Theory, News & General.

rgs92
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Re: Bonds and their role in a portfolio:

Post by rgs92 » Sat Nov 17, 2018 1:55 pm

I'm sure happy I have my healthy bond allocation this year.

WildBill
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Re: Bonds and their role in a portfolio:

Post by WildBill » Sat Nov 17, 2018 9:05 pm

Howdy

Interesting question. I do not claim to be an expert, but I will share my experience.

When I was Inā€accumulationā€ phase I had mostly equities and real estate, something like 80 %, and 20 % in fixed income,usually treasuries and CDS.

Now in retirement I have about 64% in equities and 36% in a quasi-LMP consisting of CDs,treasuries, municipal bonds and Total Bond market.

I do not like taking risks with fixed income. In my view it sort of defeats the point.

Worked for me, and I anticipate it will continue to work OK.

Good luck

W B
"Through chances various, through all vicissitudes, we make our way." Virgil, The Aeneid

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