Due to the historically low interest rate environment the past few years, many investors often ask, “why should I ever hold bonds in my portfolio?”.
First, for a clear understanding of what a bond is, a bond (aka fixed income) is an instrument issued by governments or companies to raise money by borrowing from investors, and in return, will pay interest on the borrowed money. In simplest terms, if an investor purchased a bond from a corporation, the company owes the investor back principal plus the stated interest during or after term is up depending on the structure of the bond.
If this company were to go bankrupt before the bond term is up, bond investors would have priority eligibility to get paid back before investors that have purchased stock in the same company, generally making bonds a “safer” investment than equities. In return for safety, bonds typically will provide a lower total return than stocks in exchange for lower standard deviations of risk (based on historical data).
Stocks typically require a longer time horizon to potentially achieve the higher rate of return while accounting for higher volatility. Historically, looking at rolling 1-year returns of the S&P 500, there is a 75% historical chance the index would be positive 365 days from now. If you looked at the rolling 20-year returns of the S&P 500, there is a 100% historical chance the rate of return was positive. The long-term potential for gains involves shorter term downward fluctuations and the potential loss of the entire principal amount invested.
Bonds are not used as an investment to generate a high rate of return but used for relative safety and liquidity.
For an investor that is retired and no longer collecting a paycheck from working, they may be relying on taking withdrawals from their portfolio to cover expenses and lifestyle needs on a monthly or annual basis. Retirees should be positioned to have a minimum 7 years’ worth of income needed in “safe” assets.
For example, if someone needs $240,000 (net of taxes) per year to fund their lifestyle and has $100,000 per year of guaranteed income from a pension and social security, then that leaves $140,000 per year as a portfolio withdrawal to cover the gap needed from their portfolio to cover lifestyle on top of their guaranteed income streams.
In this example, they should hold $980,000 of safe assets in their overall portfolio. This would allow them to maintain that income throughout 7 years of negative returns in equity markets without ever selling at a loss.
Taxes and inflation adjustments should be taken into consideration when determining the overall makeup.
In this example, if an investor has a 3 million portfolio, then they could safely be a 65% equity / 35% fixed income investor during retirement, and cover their income needs while weathering storms that will inevitably arise during their retirement.
In the same example, an investor that has 5 million portfolio, then they could be a 80% equity / 20% fixed income investor during retirement.
This is based on historical safe withdrawal rates, and logical sound investing.
However, for a retiree that stops the habit of saving, and also adds in the fact of taking money out of their hard earned lifetime savings, this can become very emotional. We recommend to look at any fixed income allocation over the 7 year safety net to be “peace of mind” as long as the assumed portfolio returns will sustain their lifestyle and legacy goals.
Here is an example of this in action:
This chart shows an example of taking portfolio withdrawals of $140,000 per year from an all-equity portfolio for 20 years (regardless of whether the S&P 500 was up or down).
This chart shows the same scenario (taking portfolio withdrawals of $140,000 per year), but this investor has a “safe” asset to pull from to avoid selling equities at a loss in the 4 down years.
Instead of pulling $140,000 in 2000, 2001, 2002, and 2008 (when the S&P 500 was negative), this retiree was able to pull from a safe pool of money to not take a loss in the equity market.
Having this backup improved the ending value.
The difference is about 1.8 million dollars in ending balance in the 2nd example, but when factoring in the 4 years of $140,000 being drawn from a safe pool of money, the true difference was about 1.37 million of net improvement by holding and pulling from a safe asset when equities were down.
EWA’s philosophy is to hold enough safe money to weather any storm during a withdrawal stage, but then anything above that should be invested in a diversified portfolio of equities.
This point is very important, because safe assets can help weather the storm in the short term, but are not meant to grow wealth long term.
Equities are most suited to grow wealth, outpace inflation, and produce dividends.
Surprisingly, equities have lower risk if you have the timeframe on your side.
This chart looks at 5 year periods where equities averaged 10%, but had a risk associated of 8.6% (measured in standard deviation). Bonds (over the same rolling 5 year period) had a return of 5.2%, but with a risk of 4.0%.
About half the return, but also half the risk (when looking at bonds vs. equities and investing over a 5 year timeframe).
However, when looking at the long term (30 year rolling periods).
Equities have had an 11.1% return with a standard deviation of 1.3%. Whereas bonds have 5.6% return with a 2.7% standard deviation.
So when expanding timeframes, equities maintained the 2x returns over bonds, but surprisingly this also came with ½ the risk that bonds had over the 30 year rolling periods.
This is because bond returns are dependent on interest rates and over a long period of time interest rates largely fluctuate and are very unpredictable.
So in summary, favor equities as your main holdings over your lifetime, but hold enough safe assets if you are in withdrawal stage to sustain any downturn (measured by the 7 year gap).
If you are a young investor (10 years + away from retirement), then a 6 month emergency fund will suffice. Anything that you know will be used in less then 3 years, hold in safe assets, but everything else would recommend to consider a diversified all equity portfolio.
A good plan can get you through a bad time!
Equilibrium Wealth Advisors is a registered investment advisor. The contents of this article are for educational purposes only and do not represent investment advice.
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* Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.
* Corporate bonds are considered higher risk than government bonds but normally offer a higher yield and are subject to market, interest rate and credit risk as well as additional risks based on the quality of issuer coupon rate, price, yield, maturity, and redemption features.
* The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. You cannot invest directly in this index.
* All indexes referenced are unmanaged. The volatility of indexes could be materially different from that of a client’s portfolio. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. You cannot invest directly in an index.
* The Dow Jones Global ex-U.S. Index covers approximately 95% of the market capitalization of the 45 developed and emerging countries included in the Index.
* The 10-year Treasury Note represents debt owed by the United States Treasury to the public. Since the U.S. Government is seen as a risk-free borrower, investors use the 10-year Treasury Note as a benchmark for the long-term bond market.
* Gold represents the afternoon gold price as reported by the London Bullion Market Association. The gold price is set twice daily by the London Gold Fixing Company at 10:30 and 15:00 and is expressed in U.S. dollars per fine troy ounce.
* The Bloomberg Commodity Index is designed to be a highly liquid and diversified benchmark for the commodity futures market. The Index is composed of futures contracts on 19 physical commodities and was launched on July 14, 1998.
* The DJ Equity All REIT Total Return Index measures the total return performance of the equity subcategory of the Real Estate Investment Trust (REIT) industry as calculated by Dow Jones.
* The Dow Jones Industrial Average (DJIA), commonly known as “The Dow,” is an index representing 30 stock of companies maintained and reviewed by the editors of The Wall Street Journal.
* The NASDAQ Composite is an unmanaged index of securities traded on the NASDAQ system.
* International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.
* Yahoo! Finance is the source for any reference to the performance of an index between two specific periods.
* The risk of loss in trading commodities and futures can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage is often obtainable in commodity trading and can work against you as well as for you. The use of leverage can lead to large losses as well as gains.
* Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance.
* Economic forecasts set forth may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
* Past performance does not guarantee future results. Investing involves risk, including loss of principal.
* The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee it is accurate or complete.
* There is no guarantee a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
* Asset allocation does not ensure a profit or protect against a loss.
* Consult your financial professional before making any investment decision.
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