July 5, 2022
Over the last few decades, we’ve become accustomed to a negative correlation between stocks and U.S. Treasury bonds. Bonds used to serve as a great diversifier against macroeconomic risk. Specifically, the last four downturns in 1991, 2001, 2007-2009, and 2020 were all so-called “demand-side” recessions where the drop in GDP went hand-in-hand with lower inflation because a drop in demand also lowered price pressures. The Federal Reserve then lowered interest rates, which lifted bonds. This helped tremendously with hedging against the sharp declines in your stock portfolio. And in the last two recessions, central banks even deployed asset purchase programs to further bolster the returns of long-duration nominal government bonds. Sweet!
Well, just when people start treating a statistical artifact as the next Law of Thermodynamics, the whole correlation collapses. Bonds got hammered in 2022, right around the time when stocks dropped! At one point, intermediate (10Y) Treasury bonds had a worse drawdown than even the S&P 500 index. So much for diversification!
So, is the worst over now for bonds? Maybe not. The future for nominal bonds looks uncertain. We are supposed to believe that with relatively modest rate hikes, to 3.4% by the end of this year and 3.8% by the end of 2023, as predicted by the median FOMC member at the June 14/15, 2022 meeting, inflation will miraculously come under control. As I wrote in my last post, that doesn’t quite pass the smell test because it violates the Taylor Principle. The Wall Street Journal quipped “The Cost of Wishful Thinking on Inflation Is Going Up Too“. I’m not saying that it’s impossible for inflation to easily subside, but at least we should be prepared for some significant upside risk on inflation and interest rates. Watch out for the July 13 CPI release, everybody!
So, trying to avoid nominal bonds, how do we accomplish derisking and diversification? Here are ten suggestions…
Oh, before we get started, I got one favor to ask. Please check out my recent appearance on the awesome Two Sides of FI podcast:
Eric, Jason, and I discussed my safe withdrawal rate research and my economic and financial outlook. And don’t call me the grinch of the FIRE community because I had some uplifting words for Eric who plans to retire in 2024.
Back to the issue of rising interest rates. Let me first just point out one little fun fact…
The lack of diversification between stocks and bonds wasn’t quite as bad as it’s often portrayed!
While it’s certainly true that the 10-year U.S. Treasury total return index is now almost 20% below its all-time high, keep in mind that part of the bond drawdown coincided with the equity bull market in 2020 and 2021. In other words, out of the 17.6% drawdown, “only” 10.5% occurred this year. The other portion of the drawdown came between the August 2020 bond market peak and the January 2022 stock market peak, when we still had a nice negative correlation between stocks and bonds. So, diversification from bonds was not completely ineffective. True, bonds didn’t gain when stocks lost. But at least, intermediate (10-year) Treasury bonds lost less than the stock market. Thus, a diversified portfolio would have still slightly cushioned the fall of your portfolio. Not as well as in 2008. More like in the 1970s.
In any case, if you’re still concerned about nominal bonds coming under further pressure, here are a few ideas to deal with that risk…
1: Cash is King
With cash, I don’t mean dollars stuffed into your mattress. Think money market accounts or 3-month T-bills. The advantage is that you can participate in rising interest rates without losing your shirt from that ugly duration effect. Of course, the unpleasant side effect is that nominal yields are still very low because central banks have only recently started raising rates from bargain-basement starting points. It may certainly feel good not to lose any money but with an 8+% inflation rate, your money market account still melts at an alarming rate when looking at purchasing power. But it’s a start!
Keep some powder dry and maybe even move that cash back to longer-duration bonds once we get higher Treasury yields. Then ride down the duration effect again, like in the 1980s! And maybe you can boost your money market rate a bit by rotating your money from one intro teaser rate to the next.
One caveat, though: don’t get your hopes too high that this will miraculously generate significantly better outcomes. For example, if we run my Safe Withdrawal Rate Toolkit (see Part 28 of my Series), and calculate the failsafe withdrawal rates by decade, the improvement for the 1960s cohort is pretty meager, see the table below. You get a slight boost from 3.58% to 3.66%, about a 2% boost in the fail-safe retirement budget. That’s not a big improvement for shifting 25% of the portfolio from intermediate bonds to T-Bills!
And also notice that during the 1920s and 1930s you would have done far better with the diversification benefits of bonds. But of course, the exercise here is to focus on the inflationary supply-side recessions in the 70s and 80s, not the deflationary events in the 1930s.
Treasury Inflation-Protected Securities (TIPS) are government bonds that have a fixed real rate of return, i.e., a return over and above an objective and observable inflation index, namely the U.S. (headline) CPI. If inflation is higher than expected then your return shifts up one-for-one. Sweet! That’s the definition of inflation protection!
In practice, you’ll likely not buy the actual TIPS but rather an ETF, like the iShares TIP. Unfortunately, TIPS ETFs have slightly higher expense ratios than nominal bond ETFs, for example, 0.19% per year for the iShares TIPS ETF vs. 0.05% for the overall Treasury ETF (ticker GOVT). Another problem with TIPS: the yields are still painfully low. On July 1, 2022, the yields for 5, 10, 20, and 30-year TIPS were 0.24%, 0.52%, 1.12%, 0.89%, respectively. That’s certainly better than the 0% on I-Bonds, but still very low by historical standards. Talking about I Bonds, here’s the third recommendation…
3: I Bonds
I Bonds have become something of a superstar in the personal finance community. Part of that is due to the sometimes deceptive advertising like “you can earn 9.62% in six months” as I’ve read the other on another personal finance blog the other day. That’s inaccurate. You currently earn 4.81% over the six-month window, equal to a 9.62% annualized simple (non-compounding) interest. But just to be sure, even 4.81% over six months is a very solid return when everything else is dropping like a rock. With the built-in inflation protection, your I Bonds will certainly do the trick, just like TIPS. While I Bonds share a lot of features with TIPS, there are several differences.
First, there are limits on how much you can buy every year. Usually, the maximum is $10,000 per taxpayer per year (i.e., $20k per married couple), so the average retired couple with a seven-figure net worth will not be able to move any significant chunk of their portfolio very quickly. That said, there are some “hacks” for raising this limit. For example, if you own a business and/or trust, you can get another $10,000 per entity. There’s also the option of “over-withholding” your federal taxes by $5,000 every year and then using the $5,000 federal refund to purchase more I Bonds. See The Finance Buff’s ultimate guide to I Bonds for more information. So, if you are planning a slow shift into low-risk assets during the last five years of accumulation, you can use I Bonds as one of those safe assets and accumulate a six-figure sum over the years.
Second, the value of your I Bond investment cannot go down. While TIPS can lose money when the real interest rate goes up – a duration effect just like in the case of nominal bonds – your I-Bonds are protected from changes in the principal. However, if real yields ever go down again then I Bonds will not go up in value either. So, it’s a two-sided sword!
Third, if you sell before the 5-year mark, you lose 3 months worth of interest. But again, in nominal terms, the rate is still very solid, so even if you park your money for a year in I Bonds and lose a quarter of the income you’ll likely be ahead of a money market account with a measly 1.5% interest.
Finally, the current real interest rate stinks! I Bonds currently guarantee a 0% real return, significantly lower than TIPS. With 0% real return you can pull off a 2.5% safe withdrawal rate over a 40-year horizon. With total asset depletion. I Bonds, just like TIPS, serve only as a hedge in case your equity portfolio has a Sequence Risk scenario during the first 5-10 years of your retirement. Currently, they are not a long-term solution in retirement planning!
Side note: Which one of the two, TIPS vs. I Bonds would I recommend? In light of the lower real yields and all the bureaucracy in I Bonds (annual purchase limit, registration of a Treasury Direct account, etc.), I’d probably opt for the TIPS. On the other hand, the tax efficiency of I Bonds would be a plus. Apparently, you can defer the interest for as long as you hold the bond. [thanks to commenter Spencer below for pointing this out!]
Historically, gold has been a pretty decent inflation hedge. In fact, it has been a pretty decent hedge against any kind of macroeconomic trouble, even demand shocks with disinflation/deflation. If we were to shift the 25% intermediate bonds portion to gold, the fail-safe withdrawal rates would have improved in the 1960s and 1970s. What’s more, you would have seen a slight improvement in the deflationary periods, i.e., the 1920s and 1930s retirement cohorts. Not a bad hedge!
And the usual disclaimer applies here: ownership of gold was severely restricted in the U.S. for several decades, my simulations are more of an “academic” exercise, looking at how a hypothetical investor/retiree with today’s asset allocation options (including gold ETFs, gold futures, etc.) would have fared with historical asset return patterns.
5: U.S. stocks
Yeah, you read that right. Even though the stock market doesn’t like inflation shocks in the short-term, in the long-term, stocks tend to be a decent hedge against inflation. Eventually, corporate profits will catch up with inflation, and drag prices up as well. In fact, among four major asset classes stocks/bonds/cash/gold, U.S. equity returns have put all others to shame over the last 150 years, when calculating the long-term inflation-adjusted returns.
This is probably not a workable solution for current retirees because of Sequence Risk. A 100% equity portfolio in retirement would have been far too risky in historical simulations. But if you’re still accumulating assets and your retirement date is still years away, you might just take a chance with the stock market.
In other words, my recommendation of 100% equities during most of the accumulation phase (potentially even up until retirement) is still valid, see my SWR Series, Part 43.
6: FX-hedged international stocks
How about international stocks? Well, as I outlined in a post a few years ago, if you’re afraid of a massive bear market in the U.S., then there is relatively little room to hide in international stocks because the U.S. is the largest economy and the “consumer of last resort” for a lot of the foreign export economies. Sorry, everybody, we tend to take everyone down with us if there’s trouble! But one could argue that the Federal Reserve tightening path is ahead of most of the other major central banks. The ECB is still below zero. Japan at zero. The Bank of England started raising rates but at a much slower pace. It’s certainly possible that other economies will fare better.
But not so fast, because when rates are increasing faster in the U.S., one would expect the USD to strengthen against most of the other major currencies. Then money invested in foreign equity markets will likely lose value just from the FX effect. That happened in the 1980s under Volcker and again in the late 1990s tightening cycle. In contrast, the meek policy tightening in 2015-2018 saw only a mini-rally, roughly the same size as the current USD rise. But if the 50-75bps rate hikes keep coming at every FOMC meeting, I’d suspect the dollar could move more like the 1980s or 90s than the late 2010s.
So, if you hold investments abroad, you might be better served with FX-hedged funds. But needless to say, there’s no free lunch: FX-hedged funds also have higher expense ratios and they roll the hedging costs into the fund returns as well. But if you like international stocks, at least take the FX headache out of the equation.
7: Floating-rate bonds
The obvious way to avoid your fixed-income portfolio getting hammered from a duration effect is to invest in floating-rate bonds.
But here’s the catch: If you like floating-rate bonds with low-to-no credit risk and without any duration risk, well, there’s no free lunch. You likely get yields not much different from a money market account. For example, the iShares ETF (Ticker FLOT) most recently distributed $0.0422 per share in June. That’s an annualized yield of about 1.0%, given the $50 share price. I get more than that with my Fidelity money market fund, ticker SPRXX, with a yield of 1.28% as of 6/30/2022.
If you are willing to sacrifice some safety for higher returns, there’s the Invesco Senior Loan Floating Rate ETF (Ticker BKLN). It offers a yield of about 4% (based on a $0.0661 current monthly dividend, $20.27 share price), but comes with some additional credit risk. In fact, year-on-year the fund is down about 2%. In other words, the price dropped and wiped out one year of income and then some. An FDIC-insured money market account would have performed better. But granted, that past loss is water under the bridge, so maybe the floating rate ETFs will eventually catch up and earn a superior return over a simple money market account.
There are many more ETFs in this space. I won’t research all of them but see here for a list of funds sorted by AUM.
Maybe we could increase the risk level even more. That brings me to the next point…
8: Floating-rate Preferred Shares
Taking a little bit more risk, we can push up that yield going from bonds to preferred shares. A quick recap, preferred shares are a hybrid between stocks and bonds. They pay a set dividend, which can be a fixed percentage or a floating rate, or more complicated combinations. I haven’t found many offerings of preferred share ETFs focusing on floating/variable rates. Global X Variable Rate Preferred ETF (ticker PFFV) is one.
I like to buy the individual shares because it saves me the ETF expense ratio and I can pick and choose the individual preferreds I like most. Here’s my watchlist of Floating-Rate preferreds, see the table below. A few things to point out:
- Notice that most of them are still in the fixed-rate stage, but many of them will transition to LIBOR+x% within the next few years.
- Most of the shares pay dividends that are taxed as (qualified) dividends at the lower (potentially zero) federal income tax rate. But all of the REIT preferred shares (ACR, CIM, DX, EFC, MFA, MITT, NLY, NRZ, TWO) and one of the Citibank preferreds will pay dividends taxed as interest/ordinary income.
- Notice that the interest rate is calculated relative to the $25 notional share value. But the yield is calculated relative to the actual share price. For most of the preferreds, the yield is a bit higher than the quoted rate because the shares are trading below par.
And by the way, I’m keenly aware of the irony here, because, in my Safe Withdrawal Rate Series, I’ve warned about the dangers of chasing higher yields, see Part 29, Part 30, and Part 31. Preferred shares have significant credit risk. In the Great Recession of 2008/9, the preferred market had a drawdown roughly as bad as the stock market. So, if you use preferreds today you will implicitly assume that the potential 2022 market slowdown will be different from the Global Financial Crisis. That’s not a crazy assumption because I don’t see a repeat of the subprime mortgage meltdown this time around. The large global financial sector players (Bank of America, Citibank, Goldman Sachs, Morgan Stanley, State Street, and Wells Fargo) will likely do OK. Smaller and regional players (Keystone, M&T, PNC, etc.) probably too. But I would at most “sprinkle in” the Mortgage REITs. Even though the rates adjust, the profitability of the underlying companies might not look too hot if rates keep going up at 75bps every meeting. Again, those yields certainly look juicy, but be careful with the Mortgage REITs!
Update 7/7/2022: Also check out my buddy Spintwig’s Fixed-to-Float Dashboard: https://spintwig.com/mreit-preferred-share-dashboard/. He’s done a lot of research on the REIT Preferred Shares.
9: Real Estate
Historically, real estate has been an excellent inflation hedge. No surprise here, because a big chunk of the CPI consumption basket is rent: both actual rentals and owner-equivalent rent. Specifically, the “Shelter” category in the CPI is 32% of the overall CPI and 41% of the Core CPI, according to the BLS. And rental inflation is certainly strong, see the recent Wall Street Journal article on renter bidding wars. So, even if the home price appreciation might have plateaued in many places, at least the rental income cash flow will keep gushing at increasing rates.
Talking about real estate, I always have to address the issue of physical real estate vs. REITs. I prefer the direct real estate investment route. Since I don’t want to manage rental properties myself, I outsource the “dirty” work and invest in private equity funds instead, currently at Reliant Group and Imprint Property Group (formerly known as Drever Capital Management). Broad REIT ETFs (iShares USRT and Vanguard VNQ) have experienced roughly the same drawdown so far this year as the broad market. It appears that the past appeal of REIT ETFs is now reversing as yields are finally picking up, as investors who have previously sought higher dividend yields are now dumping their REITs again. I’d stay away from REITs right now, even though some financial “experts” say that REITs are just as good as brick-and-mortar real estate investments.
10: Short nominal long-term bonds, long floating rate
I saved this one for last because it’s likely only suitable for experienced finance pros and the geeks. The idea here is that if you predict that rates go up faster than everyone else believes, then you arbitrage this through borrowing in a fixed-rate loan and investing in a floating-rate asset. If you were a “Big Kahuna” in the finance world, say a hedge fund or other large institutional investor you could do that very easily with an interest rate swap. Pick how many billions of dollars of exposure you want and contract that swap with a large investment bank.
For the rest of us with 6 or 7-figure portfolios, it’s a bit harder to accomplish that. But not impossible. We could certainly borrow at a fixed rate relatively close to the Treasury interest rate, using the technique I described in a post last year (“Low-Cost Leverage: The “Box Spread” Trade“). Currently, we can do so up to December 2026 (~4.5 years). And then invest the proceeds in a floating-rate preferred share.
The advantage of the box spread loan is that it’s fully tax-deductible, i.e., much preferred to your mortgage or HELOC where you’d need to generate a lot of interest expenditures before you even get over the hurdle of the standard deduction, i.e., before itemization on your tax return makes any sense. And the cost is deductible as 60% long-term and 40% short-term losses. So, if you can find some preferred shares with tax-advantaged dividend income, like the PNC PRP at about par that’s paying LIBOR+4.068%, that would be a nice play. Even in the worst-case scenario where the LIBOR goes back to just above zero, you’ll still make enough income to pay for the loan interest. And if rates were to go up that would be even better!
11: Honorable mention… Options Writing
Most regular readers should be familiar with my work on put options writing. The options strategy is up for the year so far. Not a bad deal considering how bad markets performed during the first six months. But admittedly, my performance was not as good as in 2019, 2020, and 2021. But with all the headwinds that’s still OK. The reason I include this only as an honorable mention is that the strategy is not really an alternative to bonds. That’s because the options trading is done on margin. Writing put options is not a substitute for a bond portfolio. It’s an add-on to an existing portfolio you already have, whether you keep your stocks + nominal bonds portfolio or replace bonds with a TIPS ETF or a floating-rate preferred share.
Here are a few asset classes that may not work very well in the high-inflation environment followed by a Paul Volcker 2.0 scenario:
- Crypto: Talking about correlations that suddenly switch. Crypto went through the same trouble. Back in the old days, it was heralded as a high-return asset with zero correlation to equities. Now crypto has much higher correlations and especially betas with the stock market, see my post “Crypto is probably a bad investment!” from a while ago. Due to the increased correlations, crypto will no longer diversify your portfolio, but likely add more risk to it. Of course, this works both ways: if inflation is all just a big nothing-burger, the economy avoids a recession, and the stock market rallies again, then crypto assets will likely pick up some of the tailwinds as well. But in the worst-case scenario, I’d expect Bitcoin & Co. to get hammered even worse than stocks and (nominal) bonds. In the two months since the publication of my blog post, Bitcoin is down over 50%. #ToldYouSo!
- International stocks without an FX hedge: If the Federal Reserve is forced to raise rates much faster and much higher than currently anticipated, we will likely see a strengthening in the USD. So, as I mentioned above, if you like non-US stocks it might be wise to hedge the FX exposure.
- Preferred shares with fixed rates: what’s worse than a 10-year nominal bond getting hammered by a duration effect? How about infinite-horizon fixed-rate preferred shares? They will have an even worse duration effect. That’s another reason why I stay away from the major ETFs (for example the iShares PFF) for preferred exposure because they have heavy exposure to those fixed-rate preferred shares. With the predictable result that PFF had a drawdown comparable to the equity market this year! In fact, too many of the floating-rate preferred shares in the PFFV fund are still years away from going floating, some of them in 2029 or beyond. Those shares might not be enough of a hedge against short-term rate hikes.
The 40-year-long bond bull market has finally come to an end. What a great run, riding down the bond yields from their 1982 peak all the way to essentially zero in the year 2020. Now we might have an updraft in yields again and safe government bonds might no longer offer as much of a diversification benefit as in the 2000s and 2010s.
If you’re still years away from retirement you might not even need any derisking. Again, refer to my classic post on pre-retirement glidepaths (SWR Series 43) from last year, justifying 100% equities through most (maybe even all) of the accumulation phase. But if you’re close to retirement or in retirement you will likely want to tread a little bit more cautiously than with a 100% equity portfolio.
There isn’t a one-size-fits-all solution. I’m still heavily invested in U.S. equities (#5) and for diversification, I use real estate (#9) and floating-rate preferred shares (#8), even with a little bit of leverage (#10) and some options trading on margin (#11). But I hope I offered a few new ideas for everybody else.
Thanks for stopping by today! Looking forward to your comments and suggestions!
Title picture credit: pixabay.com