If you are a regular reader of this blog you’ll notice that we don’t like bonds very much:
Add to that our series on safe withdrawal rates where we found that over a long retirement horizon bonds become much less attractive. In the Trinity Study with retirement horizons of 15-30 years, you can get away with a bond share as high as 50%. But over long horizons of 40-60 years in the FIRE community, the low expected returns of bonds can jeopardize the sustainability of the portfolio as we showed in part 2 of our series.
Has anything changed since last year? Are we now a bit more optimistic about bonds? After all, yields have risen. The 10-Year Treasury yield reached 2.6% earlier this year but has since fallen again to about 2.2-2.3% just last week.
Let’s look at the numbers in more detail
What is diversification anyways?
Wikipedia calls it “the process of allocating capital in a way that reduces the exposure to any one particular asset or risk”
Personally, and in this particular context, I would define it as “the reduction of portfolio risk due to allocating toward assets with less than perfect correlation”
There is a subtle difference between the two and we shall see the implications below.
How much diversification do we really get from bonds?
Specifically, how much risk reduction through diversification do we get when we start at 100% stocks (not too far away from our current portfolio) and start mixing in bonds? Let’s look at the current financial market landscape. Our current (as of 4/21/2017) Return/Risk/Correlation assumptions over the next year are as follows:
- Equities: 7% p.a. return (nominal), 15% risk p.a. (to be perfectly honest, our personal expected return assumption is closer to 6% nominal, but 7% seems more in line with what most other investors are using)
- 10Y Treasury Bonds: 2.25% p.a. return (nominal), 6% risk p.a. (A big caveat: the expected bond return doesn’t have equal the yield. We will talk more about that later!!!)
- Risk-free asset: 1.35% p.a. return (1 year CD according to Bankrate.com as of 4/21/2017). (Note: Below I will call this “cash” out of habit, though, at this one-year horizon, obviously the 1-Year CD is the risk-free asset.)
- Stock/Bond correlation: -0.30, based on monthly correlations 2007-2017
How much return/risk can we expect when going from 100% equities to an 80/20 portfolio? Let’s look at the efficient frontier diagram. We plot the efficient frontier (blue line) and the 80/20 portfolio is right on that line (by definition) with an expected return of 6.05% and expected risk of around 11.70%. That’s a pretty nice reduction in risk: 11.70% instead of 15% in an all-equity portfolio. 3.3 percentage points.
Side note: The backward-bending part of the Efficient Frontier, i.e., the lower part connecting “Bonds” with the 4.8%/3.2% dot, is normally not considered part of the efficient frontier.
But is that reduction really due to diversification? See the green line we added to connect the Stock and Bond dots? That would have been the efficient frontier if stocks and bonds had a perfect correlation of +1.0. Would we call moving along that line really diversification? I would call that “derisking” instead. So, a big portion of the risk reduction is not exactly due to diversification, but rather due to the much lower risk level in bonds.
Reduction in Risk = Effect from derisking + Effect from diversification
In the chart below, it looks like 1.8% of the risk reduction is due to derisking and only 1.5% due to diversification.
But there’s even less diversification from bonds…
In the distinction derisking vs. diversification, bonds become even less attractive when we do the derisking through cash (otherwise known as hedging). The line connecting Cash with Stocks is above Bond risk/return dot! And we can move along that line by simply mixing x% stocks with 100-x% cash, see below. With an 83.2% equity share and 16.8% cash allocation we could have attained the same expected return as the 80/20 S/B portfolio, but with a roughly 12.5% expected risk level. Out of the 3.3% risk reduction, 2.5% are simply due to hedging out some of the equity exposure. You get only an additional 0.8% from bonds.
Why the distinction Derisking/Hedging vs. Diversification?
I had this lengthy discussion with a reader about Derisking/Hedging vs. Diversification after our Great Bond Diversification Myth post. Taking the Wikipedia definition of diversification, one can certainly make the case that moving along the Stock-Cash line is indeed diversification. After all, we are reducing “exposure to one particular asset or risk” as Wikipedia puts it. But it’s still nonsensical to call that diversification. Ask yourself if someone told you that they found a way to diversify their portfolio to reduce risk by 20%. But all they did was sell 20% of all assets and put that money into cash. Would you call that diversification? No, it’s hedging/derisking. Would you be impressed? I certainly wouldn’t! It’s like someone suggested a new way of reducing my heating bill by 20%: move to a 20% smaller house.
Actually, talking about hedging, even the Wikipedia definition states:
“Diversification is one of two general techniques for reducing investment risk. The other is hedging.”
So, to the extent that hedging and diversification are mutually exclusive, simply reducing the equity exposure (=hedging) is not diversification, even by the Wikipedia definition!
How bonds could deliver zero diversification benefit: What if the Bond Expected Return < Bond Yield?
I started writing this post last week and used 2.25% as the bond expected return because that was roughly the 10-year yield on Friday, April 21, 2017. Over the weekend, Murphy’s Law of Blogging struck again: Bond yields rallied in response to the French election, right after I finished the post but before today’s publication. I thought about changing all the charts to reflect the new reality. But in the end, I didn’t. This event shows that if bond returns continue their path towards normalization, i.e., higher yields over the next 12 months, the expected return for bonds should be adjusted downward. That raises an interesting question:
How low would the bond expected return have to be to drive the bond diversification benefit to exactly zero?
If we push the expected return of bonds to about 0.8%, then the efficient frontier just exactly “hugs” the Cash-Stock line, see chart below! 10-year Treasury bonds currently have a duration of 8.0, so a relatively modest increase of 0.18% in the bond yield over the next 12 month would do the trick: 2.25-0.18*8=0.81. 10-Year bond yields went up by 0.10% between the Friday close and Wednesday morning, so 0.18% isn’t that much in one year!
Actually, I checked at my Bloomberg terminal on Tuesday (4/25/2017) and the median forecast for the 10-year rate is 2.91% by Q1 of 2018. Most economists believe a much more rapid increase than 0.18% over the next year! There are many reasons investors expect a rise in interest rates:
- The Federal Reserve is raising short-term interest rates at a projected pace of 0.50%-0.75% p.a. While this doesn’t necessarily mean that all interest rates at all maturities have to go up in lockstep, the general trend for interest rates at all maturities will be up for the foreseeable future.
- The Federal Reserve is currently sitting on a large pile of excess Treasuries and MBS (mortgage-backed securities) as a result of its various quantitative easing (QE) programs in the past. Reducing that big pile of now unwanted investments to the tune of several trillions (with a “t”!!!) of dollars is uncharted territory and financial markets are worried, see Yahoo link here: “The Fed has a problem after the biggest bond-buying binge in history.”
- Stronger growth could be around the corner after business investment looks like it’s finally gaining momentum again.
But for full disclosure, there are also reasons to believe bond that yields could stagnate or go down again:
- Geopolitical risk: U.S. Treasury bonds remain the #1 safe haven asset.
- The U.S. economy could sputter again. The 2017-Q1 GDP numbers (released later this week on April 28) will likely look really weak due to consumers.
The reality is probably somewhere in between. A weighted average of the rising rate scenario and a small probability of the stagnant/lower rate scenario will still have a rising interest path. Still bad for bonds!
How about other bonds?
We also checked how much wiggle room other bond investments have, i.e., how much of a yield increase over the next 12 months they could sustain before they lose their diversification potential. Specifically, we looked at the following iShares bond ETFs: IEI (5-year U.S. Treasuries), TLT (20+ year Treasuries), LQD (corporate investment-grade bonds), HYG (high yield bonds). They have between 0.15% and 0.30% wiggle room before any and all diversification benefit is wiped out. Not a pretty picture!
Summary
Bonds offer some degree of diversification. But don’t get your hopes up too high. Even if you believe that bond yields will not change in the foreseeable future (good luck with that!), the diversification potential from bonds is not that impressive. What’s worse, even if bond yields go up by just a moderate 0.18% (actually by less than what most forecasters believe), a stock/bond portfolio has an even worse risk/return tradeoff than a stock/cash portfolio. Bonds would have to offer much higher yields before we get interested again! If the 10-year yield reaches 3% again, which is the long-term target for the Fed Funds Rate, see Fed projections here, I might take another look at bonds!
We hope you enjoyed today’s post. Please share your comments and thoughts below!
As always, please check our disclaimers. If unsure, consult with a professional before making any investment decisions!