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| “Gentlemen prefer bonds.” - Andrew Mellon. |
The main advantage of bond funds is that they provide steady return despite (sometimes wild, like in September-October 2008)) fluctuations of bonds fund share values. Of course bonds funds are more complex that individual bonds and the shares values can fluctuate pretty widely. Bu there is such thing as average maturity. And if you keep bond fund long enough to exceed average maturity you will get the value of your principal plus initial percentage back in most (but not all) cases. One important exceptions are junk bonds which behave more like stocks.
According to Vanguard approximately 13% of participants in 401K plan had their entire accounts in fixed-income securities. That 's probably the most reasonable part of 401K crowd. Most knowledgeable part of this "bond oriented" crowd use stable value and TIPS for major ("safe") part of your 401K portfolio.
All bond investors usually do not believe in investment advisor hype and take the investment risk extremely seriously as they should. the game of 401K investing is first of all about preserving capital and only after than about returns. Who cares about 10% annual returns of your portfolio in 2004-2007 if you lost 40-50% in 2008.
| Most investors fail to understand the importance of preserving capital and the value of keeping inflation. If you could consistently beat inflation by 2 or 3 percent, you would do far better than most understand. If we assume inflation of 3% then 5% return is enough to get you far ahead of the regular pack of 401K donors in 10 years or so. |
The most important advice here: do not play with your retirement money by increasing the risk.
Corporate bonds are still risky, much more risky that stable value and TIPS. The key idea here is to identify what safe investment in 401K context means only stable value and TIPs and act accordingly. TIPS suffer from the fact that the CPI is being measured and reported by the US government, which has an very strong incentive to underreport inflation by a significant margin. So they should be used in moderation and can and should be traded. Only those two entries can guarantee you what entity can guarantee you from default risk. As we see in late 2008 it is probably the government and commodities like gold.
| TIPS suffer from the fact that the CPI is being measured and reported by the US government, which has an very strong incentive to underreport inflation by a significant margin. |
Moreover, if you are a baby-boomer you already was ripped off royally by forced switching from defined benefit plans to defined contribution plans. To a certain extend you already lost significant part of nest egg: it was confiscated by Greeenspan-Rubin-Gramm gang of "free market" for middle class, socialism for rich. In blog entry The Secret to Investment Longevity? Yyves Smith recently noted:
The Wall Street Journal's daily human interest story featured a holiday season tale of the Fuggerei, a Roman Catholic housing compound for the poor in Germany. The price of admission for those lucky enough to get in is yearly rent of one Rhein guilder, which equals 88 euro cents or $1.23, plus daily prayers for the founder, Jakob Fugger and his descendants.
How does such a marvel exist? The settlement is funded by a charitable trust, and the rent remains unchanged since the trust was established...in 1520.
Think about that. Can you think of another pool of capital that has lasted that long, let alone a commercial enterprise? The Fugger family is still well off, but no where near as rich as in Jakob Fugger's day.
The story does not give much detail about how the trust survived (a few nasty events like the German hyperinflation and World War II intervened), and gives a few tidbits about the last 200 or so years.
The core holding is forestry properties, which is both a renewable resource and inflation-hedged (admittedly with some volatility) and also owns some local real estate. The article does not indicate whether it holds securities.A fund manager who has quite a successful track record and manages money for families once told me that most investors fail to understand the importance of preserving capital and the value of keeping inflation. He said if you could consistently beat inflation by 2 or 3 percent, you would do far better than most understand. But too many investors chase greater returns, take on undue risk and in the long haul wind up worse off than if they had set more modest and attainable objectives (and note that this manager does seek and generally achieves higher returns because that is what customers want).
Annual returns have been 0.5% to 2.0% over inflation
There is a second, behavioral issue with seeking higher returns and accepting the attendant risks. Let's say you do have a good year, or perhaps even a run of good years. You come to perceive this level of returns as sustainable, when it may be luck or an unusual set of investment conditions that will not persist. But human nature being what it is, most people would increase their expenditures in line with their new level of wealth, and are ill prepared for a reversal of fortune, as the last year has shown.
Unless you are very well-to-do there is no such things as safe investing in stocks, especially this absurd idea of "stocks for a long run" (Naive Siegelism). In no way risks of stocks go away with the long run. That's a fallacy. While this is promoted in most so called investor education materials, this is a hogwash. If you buy stock it should not be static investor. You need to become a trader (you time horizon can be much larger then regular trader but still you need to became a trader). Again, repeat after me, the idea that investing in stock is safe in a long run is a hogwash. It contradicts the fundamental of economics and first of all the notion of risk premium. Risk premium for stock is approximately 2% over inflation and does not go away with the longer holding period. Otherwise stocks returns in a long run would converge with bonds. Again, the notion of risk premium discredit any muttering by people like Jeremy Siegel that you can avoid risk by taking longer time horizon. You can only diminish it by selling stocks at higher then average valuations e.g. trading (if, and only if, such a period occurs during the period you are holding them). So getting oversize returns from stock means successful trading. That's it. So on any fixed target date there in no certainty on what your portfolio will have a certain value. And never will.
The current situation is a convincing proof that you should not rely on stocks in 'safe" part of your 401K portfolio. Hedging of risk is more important then diversification for most 401K investors. And the simplest way to decrease your risk is to invest larger part of your portfolio in safe assets. The fundamental idea of risk reward is how much you should allocate to safe assets not those stupid games with various stock funds allocation that are promoted in literature. You need to think about the entity that guarantee you against default risk. Right now this is money market funds (government will seldom allow them to go down, at least this was proved in 2008) and Treasuries. And anybody who try to persuade you that this is not true is either a shill of some investment company (Siegel's of the world, see Naive Siegelism ) or complete idiots (rarely it can be both ;-).
In retirement, if you have enough saving and can live simply on interest in tough times fluctuations of bond prices don't matter. What matters is the risk of default. So here you can also use 100-your age formula and diminish percentage of corporate bonds and increase percentage of TIPS with the age. But you need to be careful what you wish for. During normal periods TIPS are competitive with corporate bonds. When they are not competitive (for example in November 2008), the risk for corporate defaults is very high and most of S&P500 companies bonds are essentially junk. Instead you might create in years close to retirement a stable value (cash) portion of your principal enough for, say, one or two years as TIPS can fluctuate wildly as we saw in 2008. This way you can avoid selling TIPS when their face value fall too low.
Another important augment in favor of TIPS is that according to Grantham model long term stock returns are inflation plus 2%. That means that they are equal to TIPS unless government underestimates inflation (which it systematically does ;-).
Medium and long term bonds including TIPS bought with yields below 5% can be as risky as stocks and should be avoided. In such cases money market funds are preferable to bonds as yields are close but the risk is completely different as recent event had shown us quite well. In any case it is wise to buy bonds only on dips.
|
Medium and long term investment-grade company bonds and bond funds bought with yields below 5% are too risky and should be avoided |
Junk bonds are more questionable but is like medicine in very small dozes (let's say 5% or less) tend to increase 10 years returns with only minimal increase of risk. But question remains open whether one can use them in (100-your age, see Lifecycle strategies) strategy as a substitution for stocks. It depends whether those companies die like fly on the frost; 2009 probably will be an interesting field test of this hypothesis.
The problem with diversified bond fund like PIMCO Total return or Vanguard intermediate fund is that they can drop dramatically in case of real crisis when bonds and stock sink synchronously while in normal circumstances decline n stock usually lead to really in bonds. That is a sad fact that many people, including myself discovered in 2008. But for 10-20 years period they still might be OK and provide slightly higher return that stable value. At the same time you need to understand that bonds funds are very different from bonds and can be very risky during crisis period. for example LQD dropped from 105 to $80 in 2008. that means that you can recover the value on you investment approximately in 5 years. So some caution is appropriate:
Never buy any bonds funds with return less
then 5%.
It is preferable to buy them as points when returns are
closer to 6% to have some cushion against decline. Stay with stable value during periods
or low return on bonds or when your 401K plan does not reasonable low expense
bond funds. The
worst mistake 401K investor can do is to move his finds from stable
value into bonds funds when return in stable value dry out. This is
a mistake equivalent to buying stocks at the top.
Be vary of buying bond founds which charge big fees.
For example I would prefer Vanguard intermediate to Pimco Total
return if both are available. Pimco guys are too greedy and their
returns are not that better them Vanguard fund but to earn the same return they
need to take more risk and if government would not bail out
Funny-Freddie Total Return might has to be renamed Total Loss.
It's nearly impossible to outperform bond fund (or EFT) with substantially lesser fees without taking more risk and
people use bonds funds to cut risk not to enhance it. In
comparison with stable value you can also pay for the errors of bond
fund managers. So PIMCO guys should be used with caution or just for
trading. Waggoner
analysis had shown that
the average bond fund with high fees can't beat T-bills over a decade
(some charged 1.77% a year in fees, vs. 1.40% for
the average domestic stock fund which is a highway robbery to say
politely).
Try to shelter gains from taxes.
That's given for 401K investors unless you contribute
more then allowed max. In the later case taxes are deferred
which is also not a bad thing. It you paid taxes on capital gains and dividends 1% average
annual gain would have
shrunk to an average annual loss of 0.19%, Morningstar says.
Rebalance only on high deviations (arbitrage), but do not trade bond funds frequently even if your 401K plan does not penalize for it. The simplest rebalancing strategy is to wait for the difference between value of simulated contributions to stable value and chosen bond fund (from a given, realistic for you date) exceed one standard deviation up or two standard deviations ( here difference is calculated as (a-b)/total_contrib ) where:
a -- total simulated value of stable value fund using cost averaging from your starting date
b -- total simulated value of selected bond fund using cost averaging from the same starting date
total_contrib -- total amount you contributed
via cost averaging from your starting date.
According to The New York Times, Baupost Group's Seth Klarman, regarded as one of the world's savviest investment managers, last year allocated a whopping 49.8% of the group's portfolio to cash, up from 45.8% a year earlier.
FPA Capital Fund, run by the legendary Robert Rodriguez, currently has a 40% allocation to cash and cash equivalents, and Fairholme Fund, my personal favorite mutual fund, allocates about 20% to cash. If those heavy-hitters like cash, it might be a good idea to give this patient approach a long, hard look.
According to The New York Times, Baupost Group's Seth Klarman, regarded as one of the world's savviest investment managers, last year allocated a whopping 49.8% of the group's portfolio to cash, up from 45.8% a year earlier.
FPA Capital Fund, run by the legendary Robert Rodriguez, currently has a 40% allocation to cash and cash equivalents, and Fairholme Fund, my personal favorite mutual fund, allocates about 20% to cash. If those heavy-hitters like cash, it might be a good idea to give this patient approach a long, hard look.
At any point of time you can find pretty convincing arguments that crash is just around the corner (next month, next quarter, the next year) but the fact that they are convincing does not mean that this is a right forecast. Seldom such convincing predictions happen in the promised timeframe. In a way it might be safer to be perma-bull of Siegel variety as you might be more often right then wrong; but if you are wrong 30% of investment can be wiped out in a year of two and it is unclear whether you have enough discipline not to move you holdings into cash in the middle of the turmoil.
At the same time it is not that easy to dismiss this strategy:
The Rule of 72 will tell you how long it takes for an investment to double in value, assuming interest is paid annually and reinvested in the same account. To get your result, simply divide the number 72 by the interest rate you expect to earn on your investment. For 4% this is almost 20 years.
Money market funds are not a bad choice if returns on bonds are below 5%. It's really stupid to expose yourself to this risk for let's say 0.3% per year difference in returns.
| Bonds funds with returns below 5% are very dangerous and during those periods a stable value fund might be a much safer bet. Never invest in bonds that have returns below 5%. Use cash instead. |
Also with biweekly value averaging and assuming we started from zero, such a strategy looks competitive to "All S&P500" strategy for older investors in "old bulls" markets in stocks as long as stable value fund interest rate is approximately 4.5% or higher. During such periods combination of stable value and Vanguard high-yield bond fund bonds (for example 80:20) might improve returns in comparison with "pure" bond funds with the same of less risk (for example Pimco Total return). My impression is that Vanguard high-yield bond fund generally has higher quality bonds then a typical junk bond fund and thus is less prone to severe declines in bear markets.
There are some tricks that can be played while staying within the limits of this strategy to increase returns. John Waggoner mentioned several of them in his recent column. Most of them are not applicable to 401K accounts but the are worth consideration for other savings, if any:
Yields on money market mutual funds also fall when the Fed cuts rates. The average money fund now yields 4.08%, down from 4.76% in August.
If you count on investment income for part of your living expenses, you'll have to tighten your already-tight belt. A $100,000 CD at 3.54% will give you $295 a month in income, which might be enough if you live in a cave atop Mount Crumpit. If you don't, you'll want to look for investments that generate more income.
Normally, you can receive higher rates by investing in a longer-term CD. But these aren't normal times. The average five-year CD yields 3.76%. On a $100,000 investment, a 3.76% yield would earn you an additional $18 a month, or about enough for a can of Who-hash.
Also, you don't want to lock in a lousy 3.76% for the next five years. Rates are more likely to rise than fall in the coming years, because of the very real threat of inflation. Inflation, at 4.3% in November, will gobble up all your interest if prices continue to rise at their current clip.
Look for banks that really want to borrow your money. Countrywide Bank, for example, will pay you 5.5% on a six-month CD.
The trade-off: Many banks that offer high deposit yields have been in the news lately, and the news hasn't been good. Countrywide, once a leading subprime lender, has been plagued by lower lending volume and rising defaults.
These banks' troubles shouldn't haunt you if you stay within the federal deposit insurance limits. (You're insured for up to $100,000 of your deposits.) The insurance is quite generous: You also enjoy separate $250,000 insurance for your individual retirement accounts, for example. For a complete rundown, go to www.fdic.gov.
If you want higher yields, though, you'll have to take more risk — including that your principal might fall. One suggestion: closed-end bond funds. Unlike most mutual funds, closed-end funds issue a set number of shares that trade on the stock exchanges, just like stocks. The twist: Many times, the market price of closed-end funds falls below the value of the fund's holdings.
Thanks to the meltdown in the credit markets, many closed-end bond funds have been clobbered. That's bad news for people who had bought the funds. But it's good news if you're now looking for high yields at bargain prices. Thomas Herzfeld, a closed-end specialist, says closed-end bond funds now offer some of the best buys he's seen in nearly 40 years.
Consider, for example, Putnam Premier Income Trust (PPT). Wednesday, the fund's shares sold for $6.14. But the fund held securities worth $7.11 a share. In other words, you'd be buying the fund's shares for a 13.6% discount to their real value.
More important, the fund's yield is a generous 5.8%, according to the Closed-End Fund Association (www.closed-endfunds.com). Other closed-end bond funds that Herzfeld likes are in the chart.
All-in-all simple binary allocations like static 50-50 (or close to it in a range approximately 60:40 to 40:60 ) split between "safe" and "risky" bonds as well as adaptation of lifecycle strategies (100 - your age and similar) might be used in bond portfolio.
Based on just simulations that I performed it looks like static 50:50 split between TIPS and corporate bonds provides not bad returns and a reasonable level of risk in comparison with the all stable value portfolio. But again I a computer expert, not financial expert.
But there are really bad periods for this combination and junk
funds in October 2008 look really bad (or suicidal, if you wish) with
drops approaching declines of S&P500. At the same time 50/50 portfolio is extremely easy to rebalance if you wish to do so
and chances that you will be losing most of your principal are
correlated with deep financial crisis when a lot of companies will go
out of business and as such you probably suffer some type of direct or
indirect losses anyway. See
also
Life cycle fund
investors Doing it wrong - Personal Finance - MSNBC.com.
All-in-all keeping all you money in money market fund or mixture of bond funds without
any stock component might be an overly defensive strategy. I suspect that there
is a minimum amount of stocks in portfolio below which the risk increases. Such a
minimum might be in the range 10-30% depending on your personality (abrupt moves
due to discomfort usually damage return greatly in a long run) and a particular stock index used
as well as bond fund in the mix. And with good selection of bond fund and stock index
the risk probably stays within bounds similar to all bond portfolio till probably
30-40%. Then it rises but until probably 60% this rise is rather slow. That
means that defensive lifecycle strategies (and
lifecycle funds, see below) might be able to provide better
returns then "cash only/bonds only" 401K portfolios with only minimally higher risk.
Here is an apt quote that describes the main problem with bond funds in 401K portfolio, the fact that your principal is at risk:
MANY INVESTORS, wary about buying bonds directly, often opt instead for bond funds, thinking, perhaps, that there is safety in numbers. Big mistake. Bond funds can be even trickier than bonds themselves because -- unlike the implication in their name -- they are not really fixed-income investments. Even when a mutual fund's portfolio is composed entirely of bonds, the fund itself has neither a fixed yield nor a contractual obligation to give investors back their principal at some later maturity date -- the two key fixed characteristics of individual bonds. [Bond vs. Bond Funds (One Bond Strategy) SmartMoney.com]
Bond funds are not panacea in comparison with stock funds, even taking into account all machination with stock prices. As we discussed TIPs are less volatile then most is should be a art of bond portfolio. You might benefit from replacing some part of stock holding with junk bond fund as they behave similarly (they are highly correlated) but have lesser volatility (interest also helps to diminish volatility during severe downturns; for example 30% drop of junk bond price with 10% interest means approximately 20% drop in your investment value).
| LIBOR, the London Interbank Offered Rate, is the most active interest rate market in the world. It is determined by rates that banks participating in the London money market offer each other for short-term deposits. LIBOR is used in determining the price of many other financial derivatives, including interest rate futures, swaps and Eurodollars. Due to London's importance as a global financial center, LIBOR applies not only to the Pound Sterling, but also to major currencies such as the US Dollar, Swiss Franc, Japanese Yen and Canadian Dollar. http://www.bankrate.com/brm/ratewatch/other-indices.asp |
But with junk funds like with socks timing is everything: they are not suitable target for cost averaging. As PIMCO Gross notes by simply researching historical annual high yield default rates (5%), multiplying that by loss of principal in bankruptcy (60%), and coming up with an expected loss of 3% over the life of future loans. So fair return for junk bonds is LIBOR + 300 or more. In other words as Gross stresses "for LIBOR+250 high yield lenders are giving away money!
It is important to understand that in current circumstances stable value funds can be a blessing as they are the only reliable hedge available to 401K investors. And if somebody is concerned about returns it's relevant to remind that average returns for 401K investors are negative after inflation. So you have nothing to lose and get peace of mind which is also very important. Money market accounts (stable value funds in 401K terminology) are the most liquid and less dangerous of bond funds and they should probably be integral part of any 401K portfolio, especially in cases where you cannot buy a bond fund that has return above 5%.
Bond funds are much complex financial instrument than bonds themselves because -- unlike the implication in their name -- they are not really fixed-income investments. Bond funds do not guarantee the return on your principal after certain number of years and for intermediate term and long term bond funds in fact can endanger your principal even if you hold them for a number of years less then maturity. Also returns can fluctuate year to year.
One of the reason is that bonds in bond fund portfolio
constantly rotate. If you try to withdraw money from the bond fund during
the period of Fed tightening you can lose part of your principal. That's why
intermediate and long term bond funds with returns below 5% (including
inflation-protected securities funds -- TIPS) are very risky to hold and are not
safe financial instruments at all.
To sacrifices stability of the stable value fund for just 1% of extra return is extremely stupid. Even with returns above 5% you should gradually displace longer maturity bonds in the portfolio as person ages in the same way as bonds should displace stocks. For the same reason bond indexes are much more questionable idea then stock indexes. Long term high quality bond funds seldom worth either the added risk or the added cost. Treasury Direct might be a simpler and better way to manage your high quality bond port of the portfolio during the retirement as government bonds are tax free.
Investment fees associated with managing bond funds investments (mutual
funds fees) are assessed as a percentage of assets invested, but for bond funds
this is a completely inaccurate method. Bond fund can be considered
partnership between you and bond fund advisors were you provide all the capital
and they provide management. That means that results should be calculated as
a percentage of return after inflation. For example Pimco with its eloquent manager
Bill Gross are taking approximately 0.5% in fees and has return of approximately
4.5%. That means that they are taking 11% of net returns for the management
of funds without even considering inflation. If we are taking about returns
after inflation and assuming inflation to be around 3% a year, they are taking
0.5/1.5=33% of return on your capital and at the same time spending a lot of
your money trying to persuade you that this an extremely good deal.
That's why bonds funds that has returns below 5%
(or Libor rate if you need to be more exact) are generally a bad deal and
you should consider using money market finds instead. I think it is prudent
to avoid buying bonds funds with below 5% returns in 401K portfolio. Please
note that bonds funds fees are not specifically identified on statements, but
can be found in fund prospects and on Yahoo finance. See
A Look At 401(k) Plan Fees for Employees for details.
Bonds are especially vulnerable during "credit crunch" when even A and AA
bonds can be affected (even AAA were affected during Great Depression).
Cutting interest rates during such a crisis (a typical government reaction)
increases inflation that has the effect of transferring wealth from
creditors to debtors. That means transferring wealth away from bond
investors.
From other point of view interest rates are just the price of money.
And low interest rates suggest devalued money and high monetary supply growth.
That is yet another way to explain why bond funds with returns below 5% are
risky to hold. In such cases stable value funds are blessing.
Gold might be blessing too.
And the last but not least: while bond funds fees usually are stated
as the percentage of assets they in reality should be stated as the percentage
of interest earned. That helps to see more realistic picture about who is the
prime beneficiary of the money you put in the fund and how much the second largest
beneficiary share is.
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Last modified: September 10, 2009