When it comes to constructing a portfolio it is generally not a matter of stocks or bonds, it is a matter of both. As a matter of fact, there are two other asset classes, cash and alternative investments that also should also be considered for a well-diversified portfolio. The percentage of each asset type, a.k.a. asset allocation, is the prime determinant of your portfolio’s return and volatility. Asset allocation is based upon the investor’s risk tolerance, which is a function of many factors including age, stability of income, family responsibilities, other resources, personal plans, and propensity for risk. There are also a number of objectives to consider such as the desire for capital preservation, current income, growth, risk aversion, and tax issues. A financial planner can assist you in determining your risk tolerance and developing an appropriate comprehensive plan. This article will primarily focus on investing in bonds and stocks. It will discuss the characteristics and considerations of these 2 asset classes. Historically, bonds have proven to be a better source of current income and safer alternative than stocks. Conversely, stocks have demonstrated to be a better source of capital growth and to be more tax efficient.
Over the last 33 years bonds and stocks have harmonized well in a portfolio. Bonds have been in a bull market for most of the last three decades as interest rates precipitously fell. In 1981 the 10-year Treasury yield was 15.84% and in July 2012 hit its low at 1.48%. At year-end 2013, it was slightly less than 3.00%. The returns for stocks over this 33 period generally were very strong and with numerous some ups and downs. The association of returns for the two asset types, known as correlation, has been quite low. The lower the correlation measure, the better the results of risk reduction brought about by combining those assets. This is what is called the “benefits of diversification”. In other words, adding bonds to an all stock portfolio reduces portfolio volatility. In finance, volatility is the definition of and a measurement for portfolio risk. Risk is the likelihood of something unfavorable occurring such as actual return differing from what is expected.
After an investor has evaluated their needs, determined their objectives and goals, a strategy for asset allocation needs to be considered. There are numerous allocation schemes such as the “fixed weightings approach” in which the asset allocation does not change over time. Another approach is “tactical asset allocation” that uses complex quantitative models to time the markets and to change the allocations systematically. A middle of the road approach called “strategic asset allocation”, or “flexible weightings”, involves periodic (annual or quarterly) adjustments to the percentages of asset type based upon market analysis.
The purpose of strategic asset allocation is to identify investments that provide meaningful expected returns for given levels of risk. Investments are categorized into four asset types: cash, bonds, stocks and alternative assets. Cash is to meet liquidity, precautionary, and “storehouse of value” needs. Alternative investments, such as real estate and commodities, are complementary to stocks and bonds. Bonds and stocks meet long-term needs and are the foundation for most portfolios. While bonds and stocks have some attributes in common, the differences are much more significant. This article will discuss the similarities and dissimilarities between bonds and stocks and when to tilt a portfolio more towards one or the other.
Historical Returns
Both bonds and stocks provide two type of return: current income and capital gains. With bonds, current income comes from fixed periodic interest payments paid over the life of an issue and capital gains primarily come from declining market interest rates or a bond rating upgrade. Stocks pay a much lower percentage of their total return (approximately 30%) as current income in the form of dividends. The majority of stock returns come from price appreciation. Stocks are definitely more risky than bonds over the short-term. In October 2007 the Dow Jones Industrial Average was 14,164.53 and plummeted to 6,440.08 on March 2009, a decline of over 54% in seventeen months. A portfolio with a 40% allocation of bonds fell 26%; less than 50% the drop of an all stock portfolio. The standard deviation, a measure of volatility, for stocks is twice the standard deviation for long-term bonds and four to five times greater than short-term bonds. As expected, the higher risk of stocks provides significantly higher total returns. The compound average nominal total return for stocks since 1926 was approximately 10%, while long-term government bonds averaged 5.5% and short-term government bonds paid 3.8%. The real return (nominal return less inflation rate) for stocks was 6.8%, 2.4% for long-term government bonds, and .7 % for short-term government bonds. A study of the data indicates that the real returns for stocks have been quite stable for the major sub-periods over the last two centuries. The real returns for both long-term and short-term bonds fell significantly from the early segment of the nineteenth century to the time period of “1926 to current day”. Long-term bond investors in the 1940s through early 1960s failed to protect portfolios from the punishing impact of inflation.
Bond Values and Returns
Figure 1 presents bond prices or values at given market interest rates and for different terms. You will observe that if the market value equals the coupon rate, the bond sells at its face value. If the market rate exceeds the coupon rate a bond will sell at a discount and the discount is larger as the term increases. The opposite occurs if the market interest rate is below the coupon rate. The market interest rate is affected by many factors such as the money supply, the size of the federal deficit, level of activity, Federal Reserve policies, and foreign interest rates. The term structure of interest rates can also be explained by numerous economic theories and hypotheses.
If an investor does not plan to hold a bond to maturity or the call date, yield-to-maturity (YTM) and yield-to-call (YTC) have little significance as an indicator of return. The alternative measure is expected return. The procedure for calculating the expected return is much like the YTM and the YTC. It is the “internal rate of return” function found by using a financial calculator, electronic spreadsheet software, or an online time value of money template. The calculation takes into consideration the actual purchase price paid and expected coupons to be collected, term to be held, and market value at termination. This measure is also known as realized return when actual data is used instead of expected sales value. Figure #2 illustrates the impact of a change in market rates to value and expected return. The example uses a thirty-year, 5% bond original selling at $1,000. If the market interest rates for comparable bonds decrease to 4% in two years, the value of the bond increases to $1,167.52 and the expected return is 12.62%. The return includes the four coupon payments plus a capital gain. However, if interest rates increase one percentage point to 6%, the value drops to $865.17 and the expected return is –1.83%. The loss is much greater if interest rates increase by 2 percentage points to 7%. All of the calculations for bond returns can be computed using the functions of spreadsheet software or a financial calculator.
Exposure to Risk
One of the biggest risk factors faced by retirees is purchasing power risk, caused by inflation. Market interest rates compensate investors when inflation is low and predictable. However, when inflation takes off as it did in the 1970’s, bonds can be ravaged. Under average inflation rates of
3.5% per year, the purchasing power of the dollar for a 20-year bond at maturity is cut by 50%. Investors in bonds need to save a significant portion (55% to 60%) of their annual coupon payment to compensate for the loss in value. Since 1926, the real return for long-term government bonds was less than 50% of their nominal returns and real return short-term government bonds was less than 20% of their nominal returns. Stocks typically outperform bonds by wide margin. Stocks definitely provide better protection against inflation because over time they pay returns in excess of inflation and over time increase purchasing power.
The major risk factor with bonds is interest rate risk. It is a mathematical certainty that as market interest rates increase the value of bonds fall (as illustrated previously). Bonds with longer maturities, lower coupons, and higher yields-to-maturity are more sensitive to the change in interest rates. These variables – coupon, maturity, and yield – are the determinants of a key metric called duration. Duration is a better measure of interest-rate risk than using maturity in that it considers both price and reinvestment risks. The link between bond price and interest rate changes involves the concept of modified duration:
- Modified duration = duration / (1 + the yield-to-maturity)
The impact of a change in interest rates to bond value is computed by multiplying the interest rate change by the modified duration. An increase in interest rates causes bond values to decline. The value of a bond or a bond fund with a modified duration of 10 years will fall by 10% if market interest rates increase by just 1%. The duration for most short-term bond funds is less than 3 years, which means the same 1% increase in market rates results in a decline of less than 3%. Duration for a single bond can be calculated using the functions of financial calculator or spreadsheet software. The duration for bonds funds is often available online at the fund’s website. Investors need to pay attention to duration. In the short-term, an increase in interest rates has a negative affect on both bonds and stocks. However, in the long-term, stocks have done on good job of reacting positively as interest rates rise.
Even though the bond market is nearly three times the size of the US stock market, bonds are difficult to sell at a reasonable price before they mature. U.S. Treasury issues are the exception; their secondary market is active. However, most corporate and municipal bonds are relatively illiquid. One of the reasons for the problem is too many bond issues. A company usually has one class of stock, but it can have many different bond issues which each trade separately. In addition to corporate bonds there are a variety of government, mortgage, municipal, foreign, and other types of bonds. There are several million bond securities in the market and only 12,000 stocks. Bond dealers are often dealing with institutional investors with millions to trade rather than the individual with $20,000 worth of bonds to sell. It is often more cost efficient to hold bonds in a mutual fund.
All securities are vulnerable to tax risk, the chance that Congress will make a change to the tax laws causing an impact to a security’s value. The Jobs and Growth Tax Relief Reconciliation Act of 2003 significantly reduced tax rates on qualified dividends, and long-term capital gains. The change significantly favored stocks and made it more advantageous to hold bonds in qualified retirement accounts (IRAs, 401k Plans, etc.). Effective for tax year 2013, the rates on dividends and capital were increased for high-income taxpayers.
Conclusion
With historically low interest rates and the potential for higher inflation rates, there are risks ahead for bonds. The current low yields provide bondholders with limited compensation for these risks. Chasing the higher yields of longer-term bonds and funds would be a mistake given the interest rate risk. Remember as interest rates increase the value of bonds decrease and bonds and bond funds with longer durations should decrease much more than those with shorter durations. If interest rate increases are slow and steady, a reasonable allocation of short and intermediate duration bond mutual should make sense from a diversification point of view. As rates increase the yields of these funds will also improve and they should generate a modest return. Rising rates mean declining prices, but the bonds will pay higher yields. Plowing back the higher yields over time generally means investors come out ahead. Treasury Inflation-Protected Securities (TIPS) may outpace conventional bonds if there is higher-than-expected rate of inflation. TIPS generated very poor returns for 2013; their drop in value has now made them more attractive to many analysts. Bond funds offer numerous advantages over individual bonds: returns are compounded over time, diversification, professional management, and convenience. Not all bond funds are the same and the differences in loads, fees, and expenses ratios can be considerable. These costs do matter. There are also many different types of funds that can be categorized by maturity (short-, intermediate-, long-term), issuer (treasury, municipal, corporate), quality (investment, high-yield), and type (mortgage-back, convertible). An investor may favor individual bonds when there is a need to generate a certain cash flow level. When balancing bonds and stocks in a portfolio, you need to be aware of the risks, make your expectations realistic, and focus on the future. Balance is the key to a diversified portfolio. A financial planner can assist investors develop an appropriate plan, monitor performance, provide the necessary discipline for success, and take corrective measure based upon changes to your facts and circumstances.
