Research Articles

How Much Bond Duration Could You Endure?

Chuck Carnevale - Thursday, July 16, 2015

Introduction

In my most recent article titled “Designing a Retirement Portfolio That’s Just Right for You” I opined that a retirement portfolio should be designed to meet the individual investor’s specific goals, objectives and risk tolerances.  I also suggested that the highest total return is not always the best approach because if the investor needs income to live off of, a focus on a consistent rising income stream makes more sense.  I continue to hold that position on the basis that there is no such thing as a one-size-fits-all when designing the appropriate retirement investment portfolio, or any type of portfolio for that matter.

My career in the financial services industry began in 1970, which was prior to the ubiquitous acceptance of Modern Portfolio Theory (MPT) within the financial services industry.  According to Wikipedia, MPT was developed in the 1950s through the early 1970s, and therefore, I feel fortunate that my original investing lessons were taught to me by experienced investors that had not yet embraced MPT.  Instead, my original teachers taught that investment selections should be based on a carefully researched assessment of the investment merits’ past, present and future of any asset class under consideration.  Simply stated, an asset class should only be included in a portfolio if it makes economic sense at the time.

Asset Allocation: The Guiding Principle of MPT

This is in stark contrast to the tenets of MPT that postulates that portfolios should be comprised of various asset classes that in theory will change in value in opposite ways.  Consequently, many practitioners of MPT routinely and automatically recommend standardized asset allocation strategies such as 60% equities and 40% bonds or fixed income.  These asset allocation mixes are routinely and adamantly recommended with usually no regard to prevailing economic circumstances.  In other words, you include these asset classes regardless.

If you think about it, it is easy to understand why the financial services industry has so ubiquitously embraced the broad asset allocation portfolio strategy.  Under MPT a portfolio needs to maintain its proper balance of X percent in equities and X percent in debt.  Consequently, portfolios require continuous rebalancing which generates activity.  Since there are usually fees and commissions associated with activity, rebalancing is good for business.  To the commission agent it generates revenues, and to the fee-based agent it provides a justification for charging their fees.  This is especially true if the advisor chooses funds with separate fees that come with a portfolio manager already attached.

As an old-school investment advisor, I have never been able to embrace or accept the MPT theories, but I understand why most of Wall Street has.  However, I will concede that under normal economic and market circumstances how a broadly diversified portfolio mix of stocks and bonds might work.  But these are not normal economic circumstances, especially on the fixed income side.  As the following 10 year Treasury graph clearly illustrates, interest rates have been in a significant downtrend since the 1980s.

An extended period of falling interest rates as shown above creates the perfect environment for bonds and bond fund performance. There is an inverse relationship between bond prices and interest rates.  When interest rates are falling, the price of previously issued bonds will rise and vice versa.  With interest rates at record lows it is only logical to assume that interest rates will move higher sometime in the not too distant future.  Consequently, I believe that bonds, as an asset class, should temporarily at least be avoided, unless of course they were purchased a long time ago.  Older bonds that were issued when rates were higher might make sense to continue holding, especially if they are getting close to maturity.

For those that would like to learn more about the relationship between bond prices and interest rates here is a link to a Wells Fargo educational piece that summarizes things nicely.  If you have any confusion about how this all works, I believe the Wells Fargo investing basics explanation will clear things up.

Two Comments on My Last Article Were My Inspiration

I was inspired to write this article because of two comments that were made on my last article.  The first comment was made by fellow Seeking Alpha Contributor Dale Roberts who often visits and comments on my work.  Frankly, and with all due respect to Dale, he and I are at polar opposites when it comes to the subject of designing and managing retirement portfolios.  Dale is clearly a MPT practitioner and advocate, and as I previously stated - I am not. 

Although this next comment is sure to raise the ire of many MPT supporters, I believe it is my solemn duty to state it regardless of who it might offend.  I have dedicated my career to countering the hypotheses of MPT because I believe it is a greatly flawed theory that does more harm than good.  However, rather than merely slinging barbs and arrows, my goal is to argue against MPT with logic and fact-based counter arguments.

Moreover, I intend to make my arguments respectfully and without condemnation or attacks on those who disagree.  Therefore, I offer no disrespect to Dale Roberts or his supporters, instead my objective is to simply state my case as clearly, logically and factually as I can.  I will let the readers draw their own conclusions and make their own judgments.  What follows next is the comment made by Dale Roberts in its entirety followed by my retort in the same comment stream:

Dale’s comment:

“Investment planning is about managing risk tolerance level and sequence of returns risk. Most investors will draw down at 4-5% of total holdings to fund their retirement. As we can see from the charts, with some very low to modest yields at various potential start dates for retirement, investors would have also been harvesting shares from these companies to fund retirement. That introduces sequence of returns risk.

Sequence of returns risk management means having assets that go up while others to down so that we do not have to sell too much of the equities (or other) as they go down in price.

Pick a retirement start date of January 2007. From that date to February of 2009 the three companies are down a collective 22.7% MMM leading the way as it really got hit hard in the recession, down almost 38%. Full recovery took a while.

If one held the broad based bond index AGG, it was up 5.2% annualized in the period. Long Term Treasuries were up 11.5% annualized. A retiree with a balanced portfolio would have been able to mostly fund this period with bond returns, leaving their equities alone. Or they could have cashed the dividends, sold no shares, and funded the rest (easily) from bonds.

Retirement planning is simple, but it must include a sequence of returns risk evaluation.

The sweet spot appears to be in that area of the 60% equities for those who will be selling down at 4% plus, inflation adjusted.

I do like the combination of lower volatility dividend growth companies with inversely correlated (there when you need 'em) bonds.”

My retort with emphasis added in bold:

“With all due respect, I once again have to take great exception to your comments. For starters, it may be true that most investors will need to draw down 4% to 5% of total holdings to fund their retirement. That is actually true with clients that I have managed money for over the past several decades. However, what is not true is that they do not have to harvest shares in order to accomplish that income goal. Their portfolios are generating enough dividend income to more than cover that need without having to sell anything.

Consequently, there was no, as you call it “sequence of returns risk.” More importantly, in addition to the fact that it need not exist if the retirement plan was carefully constructed, your comment “means having assets that go up while others to down so that we do not have to sell too much of the equities (or other) as they go down in price,” is not a given. My point being that it is quite possible that the value of both bonds and stocks can go down or rise at the same time. In other words, your notion that having 40% in bonds will ensure that you have those assets rising when your stocks are dropping is simply not true.

A true understanding of the matter involves knowing what causes a bond or bond funds to rise or fall in value. The primary reason that bonds increased in value over the timeframe you cited was because interest rates were dropping dramatically over that time period. That would not necessarily occur in a rising interest rate environment. Consequently, your statement that stocks and bonds are inversely correlated is possible in certain circumstances, and not possible in others. There is no absolute principle that states that bonds will rise when stocks fall and vice versa.

Regarding your comment about survivorship bias it is also one that I consider irrelevant. There is so-called survivorship bias in every investment that contains a group of securities out there. That would include equity index funds, bond funds etc. This is in my opinion a hollow argument that I hear all the time.

Finally, I do understand and respect the fact that you and many others like you follow and believe in the principles of MPT, I do not. I was in the business long before so-called modern portfolio theory became the rage of Wall Street. It’s a great theory because rebalancing causes activity and Wall Street loves that. However, in what I like to call the good old days or Ancient Portfolio Reality, investment decisions were based on a deeper understanding of business economics and accounting over statistical inferences. Recommending bonds in a low interest rate environment like we have today is in my opinion a very dangerous recommendation. When interest rates do rise, existing bonds are likely to get crushed regardless of what the stock market is doing.

Regards,

Chuck”

It’s Important to Know Why Performance Happened

Although there were many things about Dale Roberts’ comment that I disagreed with, and stated so in my retort, the true inspiration for this article was based on the following excerpt:

“Pick a retirement start date of January 2007. From that date to February of 2009 the three companies are down a collective 22.7% MMM leading the way as it really got hit hard in the recession, down almost 38%. Full recovery took a while.

If one held the broad based bond index AGG, it was up 5.2% annualized in the period. Long Term Treasuries were up 11.5% annualized. A retiree with a balanced portfolio would have been able to mostly fund this period with bond returns, leaving their equities alone.”

Clearly Dale was offering the performance of the bond index AGG as evidence in support of his position that a retirement portfolio should contain 40% bonds.  Now, I do not doubt that the performance of AGG was in fact as stated.  However, I do not believe that it provides supporting evidence for owning bonds in today’s interest rate environment.

The following graph courtesy of FRED covers the interest rate environment over the timeframe that Dale referenced in his comment.  The reason that AGG performed as well as it did was because interest rates were dramatically falling thereby simultaneously increasing the prices of previously issued bonds.

However, I believe that logic dictates that interest rates are highly unlikely to be as benign over the next several years.  Therefore, logic also dictates that it is highly unlikely that AGG, or any other bond or bond fund, will perform as well in the future as it did over that timeframe.  It’s not enough to just know what performance was, it’s more important to know how and why it happened.  An even more important to have a well-reasoned perspective of what might happen to the performance of bonds in the future.

The Second Comment That Inspired This Article

In response to my retort to Dale Roberts’ comment I received a follow-up comment from FinancialDave, who is also a fellow Seeking Alpha contributor.  With all due respect to FinancialDave, his comment gave me the impression that he was attempting to explain to me how bonds work.  Therefore, assuming he was trying to be helpful, I think it’s important for me to state that I have a long experience managing bond portfolios over the past 4 ½ decades.  In other words, I believe I clearly understand how bonds work.

But more importantly, I want to take this opportunity to emphatically state that I am not generally against bonds or the utilization of fixed income instruments in retirement portfolios.  However, I am temporarily eschewing fixed income instruments because I do not believe they are sound investments under today’s interest rate environment.  But more specifically I am currently avoiding fixed income because I believe that the traditional advantages that bonds have typically offered are no longer evident, at least temporarily.

Many investors, and apparently that includes FinancialDave, hold the position that bonds are innately less risky than stocks.  I have never bought into that argument even when bonds were more relevant than they are today.  Later in the article I will discuss why I believe the notion that bonds are innately safer investment vehicles than stocks may not be entirely true.  But before I do that and for the readers perspective I offer FinancialDave’s comment in its entirety as follows:

“Chuck,

When interest rates do rise, existing bonds are likely to get crushed regardless of what the stock market is doing."

This is no different than the price of a dividend stock going down in times of a market upset. The price of the bond fund will go down but your income will not change, except that if you are reinvesting the income your income will go up.

The reason that bonds are less risky than stocks is for the simple reason that when you buy a bond fund (or a bond for that matter) you know exactly what income you can expect over what's called the "duration" of the bond fund. In other words if you buy an intermediate bond fund yielding 3% with a duration of 6 years, it really doesn't matter if interest rates go up 2% because over the next 6 years you will have returned an average 3% yield per year on your original investment, and if you reinvest the interest the yield will be more.

Now if you buy a stock and expect to hold it for 6 years you really don't know if the income will go up / down / or stay the same over the 6 years. Of course you hope it continues to increase but it certainly can just as easily go down, which is really not the case with your bond fund - barring any large bond defaults.

Many people do not understand the above and are thus deathly afraid of the coming interest rate hikes.

Personally, I have very few bonds because I just view them as not providing enough yield for my liking. Once interest rates do move I will consider "locking in" more of a higher yielding return because frankly there is no downside to the income side of the equation (unless you feel interest rates will be lower out beyond the duration of your bond.)

P.S. the other rule with bond funds is you should never buy one with a duration beyond where you think you will need the principal - much like you don't want to sell your dividend stocks when the market is down.”

I did not retort FinancialDave’s comment in my original article because I felt it was worthy of a more comprehensive response than was possible in a comment thread.  Consequently, I will present my response in the format of the remainder of this article.

For starters, the last paragraph in FinancialDave’s comment indicates that he and I are in general agreement regarding the reality that bonds are not providing enough current yield.  The reasons I had chosen to invest in bonds in the past was not because I believed they were necessarily safer, it was because they generally offered more current income than stocks when interest rates are within historical normal ranges.  Therefore, I invested in bonds for their higher current yields, and I will admit for the reliability I could expect with those yields.  So I will concede that the income stream from a bond might be more predictable than that of a stock, but safety is another matter altogether.

When I first entered the financial services industry, a mutual fund wholesaler who represented the American Funds family of mutual funds (primarily equity funds such as ICA and Washington Mutual) introduced me to a concept about bonds that he called “guaranteed failure.”  His point was that due to the unavoidable effects of inflation, that investing in fixed income under normal times almost always resulted in real economic loss.  He acknowledged that quality bonds would return your principal and were almost guaranteed to make all of their interest payments.

However, he further pointed out that bonds only did that in nominal terms.  Over time inflation decreased the value of your future return dollars and the purchasing power of future interest payments as well.  Thus, the valuation of your investment coupled with the ravages of taxation, assuming your bonds were held in a taxable account, were almost certain to generate a real economic loss.  This is what he meant by guaranteed failure.  You were virtually guaranteed to get your originally-invested money back, and you were virtually guaranteed to get all your interest payments, however, at the end of your holding period neither of those dollars would purchase what they would when you originally invested your dollars.

Of course, this mutual fund wholesaler was biased towards equities, but his point was well taken.  Common stocks offer little or no guarantees as to their future value or the amount of dividend income you might receive, as FinancialDave so rightfully indicated in his comment.  On the other hand, high quality dividend growth stocks at least provide the opportunity for an increasing dividend income stream and additional capital appreciation that could fight the ravages of inflation.  Common stock investing does not come with any guarantees, however, they do provide the opportunity for real economic success. 

The following US inflation calculator measures the devaluation of the purchasing power of a dollar since 1996.  I offer this to provide the reader a perspective regarding how much income and capital appreciation growth would have been necessary to fight inflation since 1996.  A simple approximation is your investments today would have to be worth at least twice as much as what you originally invested.  Keep that number in mind when I present a few examples of the performance of high-quality dividend growth stocks over that same timeframe. 


The reason I presented the above calculation is to counter FinancialDave’s argument:  “The reason that bonds are less risky than stocks is for the simple reason that when you buy a bond fund (or a bond for that matter) you know exactly what income you can expect over what's called the "duration" of the bond fund.”  

In nominal terms he is correct, but in real purchasing power terms you do not know exactly what income you can expect.  Of course, that also holds true for equities.  The only real difference is you have a specific number with a bond, and opportunities, but nothing specific for capital appreciation and a growing income stream with equities.

Dividend Growth Stocks Versus Bonds: During the Golden Age of Bonds

As previously illustrated, interest rates have steadily fallen since approximately the mid-1980s. From the perspective of bond price action this could be thought of as the golden age for bonds. In other words, as rates fell in front of previously issued bonds, there was no downward pressure on the pricing of previously issued bonds. Consequently, the investor’s portfolio statements for their bond holdings were always positive. This clearly supported and promoted investor confidence in bond investing. However, there was also an insidious side. As previously-purchased bonds matured, the yields on replacement bonds were significantly less than investors were used to earning on their money. Also, even though bond prices were strong, thanks to the tailwinds of continuously falling interest rates, there was also the persistent effect of inflation.

The following simple spreadsheet illustrates the effect that inflation had on purchasing power of a Treasury bond issued in 1996. The yield on the 20-Year Treasury bond in January 1996 was 6.11%. However, inflation over that timeframe averaged approximately 2.7%. Consequently, even though the bond paid a consistent 6.11% for 20 consecutive years, and even though buy-and-hold investors got all their money back at maturity, it clearly didn't buy what it did in 1996.

On the other hand, and in defense of Treasury bonds in 1996, they were paying a higher interest rate than investors could have received by investing in high-quality dividend growth stocks. Therefore, they made investment sense for those investors that needed more income than dividend stocks offered. In 1996, I still favored bond allocations for investor portfolios that needed the yield. But unfortunately, that's not the case today, which is why I currently do not consider bonds as an appropriate asset class as a result of today's low interest rate environment.

Dividend Growth Stocks No Guarantees but Opportunity to Fight Inflation

To illustrate the difference of investing in high quality dividend growth stocks versus investing in the less risky 20-Year Treasury bond, I offer the following earnings and price correlated F.A.S.T. Graphs™ on two high-quality dividend growth stocks United Technologies (UTX) and Target (TGT).  I specifically chose these two companies as examples for two primary reasons.

First of all, both of these companies offered significantly lower current yields than the 20-Treasury bond, and second, both were reasonably valued at the beginning of 1996.  This last point is critically important because I believe one of the best ways to mitigate the risk of investing in equities is to be disciplined about valuation.  Stocks might in fact be riskier than bonds, but when you invest in high quality dividend paying companies at sound valuations, the risk differential is greatly reduced.

On each example I provide an earnings and price correlated FAST Graph since 1996, the associated performance reports and a FUN Graph illustrating the dividend growth for each company.

United Technologies Corporation

United Technologies has increased their dividend every year for 22 consecutive years.  The long-term earnings growth rate was 11.5%.  Stock price was clearly volitale over the short-run, but in the long-run price tracked earnings generating long-term capital appreciation. 


Although United Technologies started out with a yield disadvantage to the 20-year Treasury, over time it generated more cumulative dividend income than the total interest payments on the Treasury.  However, even if you adjust the dividends for inflation, your net inflation adjusted result would only be slightly less than what you earned on the Treasury net.

However, the additional capital appreciation, even after being adjusted for inflation, significantly compensated you for the so-called additional risk.  Stocks may be riskier, but the risk is not as great as many assume, especially when you invest in quality at sound valuation.




Target Corp (TGT)


Although Target also started out with a yield disadvantage to the 20-Year Treasury, over time it generated more cumulative dividend income than the total interest payments on the Treasury.  However, even if you adjust the dividends for inflation, your net inflation adjusted result would only be slightly less than what you earned on the Treasury net.

However, the additional capital appreciation, even after being adjusted for inflation, significantly compensated you for the so-called additional risk.  Stocks may be riskier, but the risk is not as great as many assume, especially when you invest in quality at sound valuation.



Summary and Conclusions

I do want to be crystal clear that I am not suggesting that bonds cannot be safe investments. Nor am I suggesting that stocks are safer than bonds. However, I am suggesting that the differentiation of risk between high-quality blue-chip dividend stocks versus bonds is not as great as many suggest. I have always understood and considered bond returns to be more predictable than stock returns. But because of the ravages of inflation, I have never considered bonds to be as safe as many also suggest.

As a bonus, I have prepared a free analyze-out-loud video on my website MisterValuation found here that provides a more in-depth and detailed analysis on the risk profile of Stocks vs. Bonds.

Disclosure:  Long UTX, TGT at the time of writing.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.


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“About Chuck's F.A.S.T. Graphs™: They are invaluable to me in making decisions about the stocks I own (in addition to what you are saying about doing other research) and the ones I hope to own in the future.”


"Chuck -- Your proprietary F.A.S.T. Graphs™ are a VERY impressive tool!"


“If there were an Investor Hall of Fame for people who have helped others with their investing, and sharing valuable information, you and your F.A.S.T. Graphs™ would get one of my selections.”


“I love Chuck's F.A.S.T. Graphs™! Well worth the price of admission for what he gives you.”


"Chuck - Thank you for your well thought out articles. I tend to be a visual type of person so I really appreciate the F.A.S.T. Graphs™ approach."


"Great article, as always! I always look forward to your articles, and am especially eagerly awaiting your next in this series. I find the F.A.S.T. Graphs™ extremely helpful."


“Your F.A.S.T. Graphs™ put all of this in a single artful picture and the accompanying spreadsheets hammer home the point.”


“I use the F.A.S.T. Graphs™ method to evaluate all of my ideas. I recommend it for individual investors, since it helps them focus on data and get past the many emotional arguments.”


“I recently subscribed to the F.A.S.T. Graphs™, and these articles are helping me learn how to better use them. They really do give you a good quick look at the valuations picture. A much needed tool!”


“I also always appreciate the clear-cut information provided through your F.A.S.T. Graphs™ and articles.”


“Thanks, Chuck, for your F.A.S.T. Graphs™. Each of these graphs is worth 1,000 words in describing a company's growth, consistency and valuation. Thanks for sharing your graphs.”


“Thanks, Chuck. Love the F.A.S.T. Graphs™! It makes investing so much more clear.”


“Chuck's F.A.S.T. Graphs™: They are invaluable to me in making decisions about the stocks I own (in addition to what you are saying about doing other research) and the ones I hope to own in the future.”


”I am amazed at the usefulness of your F.A.S.T. Graphs™ and I plan on using them for a long time to come.”


“Chuck's F.A.S.T. Graphs™ will give you a tool to find those well chosen stocks...”


“Thanks for the F.A.S.T. Graphs™, Chuck. They are the best tool I've used.”