Think Outside the Bond

In last month’s newsletter, “The Breakdown on Bonds,” we dove into a discussion about the investment instrument we call “bonds” and how sometimes – like right now – they “misbehave!”

We also looked at why they do not dampen risk in our investment portfolios to the extent many believe or advise. In short, they should not be the “go-to” investment option for our current volatile markets. And, if fact, I would argue that the advice to load up on bonds in your portfolio in times of market turbulence is as outdated as a rotary phone or dropping your film off to get it developed!

So, in this second installment on bonds, let’s unpack in greater depth the smarter strategies with bonds – when to use them and especially when not to use them. Let’s “think outside the bond!” . . . “Imagine That™”!

Bonds Are Not the Safety Net We Have Been Led to Believe

Last month’s article pointed out that monthly/quarterly payouts from bonds are generally stable. That said, the actual “value” of the bond – what you get when you sell it – is NOT stable. It “wiggles”. . . a little or a lot, depending on when the bond matures, or in regular English, when you receive your money back!

To see a concrete example, let’s look at last month’s results in what should be a boring, straightforward bond investment – the Vanguard Short-Term Bond ETF (short for “exchange traded fund.”) For the month of March, we saw the fund decline in price by over 2% even though its income payout remained consistent!

The 30-day yield from this Vanguard Short-Term Bond ETF started March at approximately 2%.  That gives a grand total of 0% net return BEFORE factoring in fees, taxes, costs, and runaway annual inflation which is now at 8 ½%! Ouch!! And for bond funds that have a “pay back timeframe” that is a mid-term or long-term . . . they got hammered and lost a great deal of value even considering their monthly yield to investors.

OK . . . so what if March 2022 was a “statistical anomaly?” That is, just a random occurrence?

Let’s look instead at 2021 when markets were much “calmer” and inflation was deemed “transitory.” Perhaps 2021 should be a better time to have invested in bonds according to traditional investment wisdom, right?

The twelve-month performance of the Vanguard bond ETF mentioned previously –  ending March 31st, 2022 – yielded a negative return of nearly -4%! Double ouch!

So, what is an investor to do in these times of high volatility (or high “wiggle”), high inflation, and negative returns when accounting for fees, taxes, and inflation? We need to “think outside the bond!”

We Need Real Returns and Should Ignore Nominal Returns

Interest rates have been on the rise. That’s welcome news for investors with money looking for a new home, but there is a catch.

Those headline rates we see in our financial media are the “nominal” rates of return. It frankly doesn’t mean a thing to our wallets. They, instead, only recognize what is called the “real” rate of return. What’s that?

The real rate measures what happens to our spending power. It is the nominal rate minus inflation. Those 2% nominal rates suddenly lose appeal when inflation is creeping up toward double digits – the highest inflation rates in 40 years! Let’s do the math: 2% nominal rate of return less 8 ½% inflation and taxes of ???%. Ugh . . . .

OK . . . so we have established that the “safer” bonds come with a major helping of negative returns after inflation and taxes. Finding a positive real return in bonds today ironically adds considerable risk to what is supposed to be a reliable, safe investment.

Note: There is such a thing called “I Bonds” from the U.S. government. The rate of payment keeps pace with Consumer Price Index data every six months. The purchase limit, however, is $10,000 maximum per person plus an additional $5,000 of Federal tax refund. Sorry . . . that’s all there is!

The current inflation rate does not allow for the luxury of parking our cash into safe short-term bonds that offer a positive real return. Those days are gone – at least for the foreseeable future.

Speculation in the bond markets in an attempt of finding positive real returns simply creates another risky asset class. There are so-called “high yield bonds” that do just that. They are, however, a lower credit quality and sometimes go by another name: “junk bonds!” These bonds generally pay a higher income because of the greater risk of default by the municipality or business selling them. Some investors try it, but it defeats the purpose of allocating investment capital to bonds in the first place if you are doing so to have greater “safety” in your investment portfolio.

Buckle Up Your Seatbelts, Volatility is Here to Stay

 I hate to break it to you, but volatility is here to stay and is the “new normal.” Theories abound regarding the causes of the increased market volatility – but several are:

• Health crisis (notably COVID-19)
• The threat of terrorism, violence and war (notably Russia’s war with Ukraine)
• Globalization and interdependence of businesses and industries
• Tariffs between global trading partners (notably the U.S. and China)
• Civil and political unrest
• Economic uncertainty
• Increased computerized program trading
• The simple fact that more people are trading in the markets today than ever before

As well, since individuals make decisions based mostly upon either fear or greed, there is also a great deal of emotional buying and selling. This, in turn, reinforces dramatic price and market swings. (The “wiggle.”)

If you would like a deeper dive into the issue of volatility, please read our newsletter called “Volatility: The ‘New Normal’ Why traditional Investment Strategies No Longer Work Well.”

Don’t Fear “Risky” Assets, “Manage” Risk Instead

Ironically, for the foreseeable future, having a diversified portfolio of equities might bring better income stability than a portfolio allocated primarily to bonds. Portfolio growth in this low-interest rate, high-inflation environment becomes crucial for many investors near or in retirement. At the same time, successful retirement planning depends largely on making sure your retirement account doesn’t plummet in value.

Real damage to a portfolio happens not just when asset values fall, but in the combination of diminishing asset values plus the need to draw on the account for income purposes. That need could come from living expenses, which can sometimes be scaled back, or from Required Minimum Distributions which force out a certain amount of income per year depending upon your age. (RMDs now start at age 72, where before it was age 70 ½.)

Fortunately, an easily measurable, low-cost, and diversified investment strategy has been created which removes emotion and the temptation to use “tactical” allocations from our investment decisions. (A tactical allocation actively shifts the investment portfolio asset allocations in an attempt to take advantage of the major economic conditions.) Using this back-tested investment strategy allows for growth of our money, while at the same time, limiting risk.

This investment strategy entails creating diversification through what are called “Exchange Traded Funds.” Our money gets equally split initially between the eleven “sectors” of the U.S. economy. Investing across all eleven sectors helps offset the “risk” from indices like the S&P 500 index. Over the years it has become concentrated in the technology sector (along with the financial sector of banks and insurance companies). The technology sector specifically is focused in a handful of mega-cap stocks like Google (Alphabet Inc.), Microsoft Corp., Facebook (Meta Platforms, Inc.) and Amazon.com, Inc.

Did you know Apple Inc. just by itself represents approximately 7% of the S&P 500? How’s that for diversification? Not . . . .

Instead, our investment strategy for finding “real returns” while minimizing risk in the current volatile market uses something called a “stop-loss.” This feature helps protect your investment from calamitous drops in market value. We don’t know (and will never claim to know) how far stocks might fall on any given day/week/month . . .  but doesn’t it just make good sense to get “out of the way” of a drop greater than 10%?

A second important component of our investment platform involves “rule-based parameters” derived from measuring the past 14 recessions occurring in the U.S. since the Great Depression of 1929. This helps determine when to move out of defensive investments like bonds and cash and back into equities. No emotions. No crystal ball predictions.

We use a battle-tested analysis of the past 90 years of recessions – and recoveries – to provide an intelligent point of reentry into equities. The longer it takes the market to find its equilibrium, the higher the “bounce” necessary from the market low before repurchasing equities in the eleven sectors of the U.S. economy. This unemotional and disciplined approach has proven itself again and again for getting out of bonds and cash and back into equities.

Do understand this . . . it is impossible to consistently time the market. As the famed investor Peter Lynch put it, “Far more money has been lost by investors trying to anticipate corrections than lost in the corrections themselves.” By using this strategy, however, we protect our invested capital when the stock market is in retreat. As well, the strategy moves money back into equities when the temptation is to sit things out on the sidelines. We can move with markets to significantly minimize disruptions to our retirement and provide stability of income.

Conclusion: It’s Time to Think Outside the Bond!

Markets change. That means our retirement planning strategies need to change as well. There is still a time and place for bonds in a investment portfolio. It makes little sense, however, to follow the outdated rule, written in a different era, to overweight a portfolio with bonds during times of economic volatility.

As we have put forth, holding a large percentage of bonds no longer fits many retirement plans, especially as it leaves investors more susceptible to risk. Instead, “think outside the bond.” If you need income, withdraw funds systematically from a balanced, low-cost equity ETF portfolio spread over all sectors of the U.S. economy. If you do this, you may find an investment program which provides greater income, and at the same time, provides a much better opportunity for growth in your retirement account(s).

Do you have any questions? If so, let’s schedule a complimentary 20-minute conversation to explore if a more modern and strategic investment plan is right for you. Using equities to provide greater diversification and discipline in your retirement portfolio to reduce risk to principal and increase the “real rate of return” of your retirement income . . .”Imagine That™”!