William Bernstein: Picking The Right Bonds For Your Portfolio

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pie_flat_blank_200Author and investment advisor William Bernstein wrote a thoughtful WSJ piece on bonds, which I think is useful for the DIY investor. The overall theme is that you should take minimal risks with the bonds in your portfolio. Taken in isolation, some types of bonds are likely to provide higher long-term returns than others. However, you should consider how they fit into your entire portfolio. Historically, it has been more efficient to take your risk with stocks and use your bonds for their stability. Bonds become the “dry powder” you can use to buy more stocks after a crash (rebalance!).

I found myself breaking down the article into three main categories. The types of bonds he recommends most, the ones he considers acceptable, and the rest which should be avoided. These are my short notes; read the article for the supporting arguments.

PREFER


  • Individual US Treasury bonds, manually laddered.
  • US Treasury bond mutual funds, for smaller balances.
  • Top-yielding FDIC-Insured Certificates of Deposit, manually laddered.
  • Short-term or intermediate-term, higher-quality municipal-bond funds, for large taxable balances.

OKAY

  • “Total bond index” mutual funds, as they consist mainly of high-grade, government-backed bonds.
  • US Treasury bond mutual funds for larger balances.

AVOID

  • All corporate bonds, but especially avoid lower-grade and/or longer-term corporate bonds.
  • Lower-grade and/or longer-term municipal bonds.

I would point out that inflation-protected bonds (TIPs) are not mentioned directly, I guess because they aren’t directly comparable to these nominal bonds. Either that, or he just considered them to be the same as traditional Treasuries. He talks about TIPs a lot elsewhere (including his books), so a little specific advice would have been helpful.

My other opinion is that running your own bond ladder is quite doable but only the most DIY of DIY investors would do it better than a low-cost bond fund. I own individual TIPS and it’s not hard but not a ton of fun either to keep track of auction dates and avoid cash drag. Vanguard charges only 0.12% annually for their short-term government bond ETF (VGSH) and Admiral fund equivalent. $12 a year per $10,000. $120 a year for $100,000. I’d rather just pay that unless I had millions or I had a lot more free time. However, if you’re already paying a financial advisor, I would let them manage an individual bond ladder as part of their fee.



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Comments

  1. Nick Kapur says:

    Isn’t the point of laddering your own bonds more than just the expense ratio, but also that you have the option of just holding them to maturity and never losing any principal, whereas with a bond fund (even a low-cost Vanguard one), if interest rates rise you will *definitely* lose money?

    This concern seems even more relevant as the Fed gradually eases into raising rates…

  2. I have been trying to wrap my head around a strategy of owning bonds or bond funds. Below are some good reads

    Misconceptions About Individual Bonds vs. Bond Funds
    http://awealthofcommonsense.com/misconceptions-about-individual-bonds-vs-bond-funds/

    Five Myths of Bond Investing
    http://www.wsj.com/articles/SB10001424052702303636404579395543442224618

    A topic of current interest: Bonds or bond funds?
    https://personal.vanguard.com/pdf/s354.pdf

    • Nick Kapur says:

      Thanks for these links. But that said, I’m not convinced at all by the argument in the first article. Think of it this way. Let’s do a thought experiment where you have $5000 to invest in bonds immediately, and you are choosing between either investing all $5000 in a bond index fund, or all $5000 in a single long-term (say, 10-year) treasury bond issue. Now, in an environment where future interest rates are uncertain, we can agree that these two choices are more equal and indeed, that the bond fund will be superior for all the reasons outlined in the first link above. But, right now in October 2015, with rates about as low as they can possibly go, we can actually be pretty much as close to certain as we can be that rates will be higher 10 years from now. This means that whereas our $5000 invested in a single bond will still be there in 10 years, the $5000 in the fund will be much less. Some of this loss will be offset by the bond fund rolling into higher-interest bonds over time, but probably not all of it, and besides, you could achieve the same thing by laddering your own bonds. So while it’s true that the $5000 received back at maturity will be degraded by inflation, the much less than $5000 in the bond fund will be just as degraded by inflation, and still be less principal! In sum, if we have no sense at all of which way interest rates will go, then a fund makes sense. But that is not the case now, as we come to the end of a monstrous 30-year bull run in bonds. This is why I’d rather be laddering my own bonds, or if my time horizon is long enough, not owning bonds at all.

      • Hi Nick. I wish we could discuss this over a beer vs blog comments, but alas, comments will have to do.

        Note: I am NOT an expert, and I am trying to figure this out myself.

        Let’s say you buy that $5000 bond, and interest rates rise from 3% to 4% (completely made up numbers). Whether you look it up or not, the bond has dropped in value (let’s say the new value is $4000).

        Now, let’s assume that interest rates do not rise anymore for the duration of the bond. As the bond slowly approaches maturity, the price slowly approaches $5000 again.

        Price Convergence
        When a bond is paid off, or redeemed, at maturity, the bond issuer pays the bond’s owner the par value. Consequently, as the bond nears maturity, the price moves close to the par value. Why this occurs is pretty simple. A bond owner won’t sell the bond at a discount price when she will soon receive the higher par value amount, so potential buyers have to pay more. Buyers won’t pay much of a premium price for a bond nearing maturity because they will receive only the par value when the bond is redeemed.

        A year from now, the bond may be priced at $4100. 2 years from now it will be priced at $4200..etc…at maturity, the bond will be priced again at $5000, as the original investment is to be returned.

        In addition, if you ladder your bonds, you are essentially creating a mini mutual fund. As rates rise, the older bonds will drop in value, and the newer bonds will have a higher return (same as a mutual fund). You are choosing to not to value your bond portfolio with current prices, but instead, complete your calculations based on the bond maturity values. If you need to sell your bonds immediately, you cannot assume bond maturity values, you need to assume present day values (which is what a bond mutual fund price reflects).

      • @Nick Kapur

        “…we can actually be pretty much as close to certain as we can be that rates will be higher 10 years from now.”

        Tell that to the Japanese! We are in a global deflationary, low economic growth environment with governments waging currency warfare, and there’s no telling how long rates will be low. Don’t be so quick to assume rates have to go up just because they’re low today. They can also stay so for a prolonged period, a la Japan.

  3. I see no reason to pay an annual management fee of 0.12% – 0.20% per year for picking treasury bonds, particularly in a low interest environment like todays. Picking your own treasury bonds could be well worth the time.

    One can easily create a ladder of TIPs or CD’s or Treasury Bonds by purchasing staggered maturities from a broker like Fidelity/Schwab/Vanguard etc. You do not need to wait for auctions – right now Fidelity shows 31 TIPs bonds with maturities between 2016 and 2045.

    Alternatively, building your own CD ladder will provide you with a better yield than corresponding Treasuries, without any incremental default risk ( as long as you are within the FDIC limits)

    • As frequently as auctions occur I don’t see a compelling reason not to wait. By buying at auction you avoid markups and get the same price the big boys on Wall Street get. Sincd buying at auction and holding until maturity has zero transaction costs you’re actually doing better than Wall Street since they have necessary overhead associated with making the purchase.

  4. italiangirl2020 says:

    I have Vanguard Short Term Corporate Bond Fund and I think it’s pretty good. This article says to avoid corporate bonds. Why? It’s never let me down, even in 2008. It doesn’t yield much but I use it almost as a “cash” resource.

  5. eric pease says:

    Any reason no one is talking about university issued bonds like bonds from Stanford University? too much risk? I know literally nothing about bonds but recently read an article about the returns on university issued bonds.

  6. I also have Vanguard Short Term Corporate Bonds. These do not pay much but seem like an okay place to hang out while interest rates tick-up the next few years. Why does this article have such a negative take on Corporate Bonds with B and higher ratings?

  7. Would love to know more about why to stay away from corporate bonds. I’m surprised to learn that you recommend AVOIDING those, rather than them just being ok, as they might not offer you the biggest and quickest gain

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