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Tue. Jul. 21, 2009

Bonds: The Next Bubble to Burst? *

One of the key tenets of investing with an asset allocation model is that bonds and stocks working together will help reduce the volatility of your portfolio.  Recent history has shown that while stocks crashed, bonds soared and those fortunate enough to hold them generally did better than those invested entirely in equities.

Recently I read a couple of articles in Yahoo Finance and The Wall Street Journal looking at bonds both from a historical perspective and future prospects. Here are some key points from the articles:

  • As of June 30, U.S. stocks have underperformed long-term Treasury bonds for the past 5, 10, 15, 20 and 25 years.
  • Using data from research firm Ibbotson Associates, large-company stocks have returned 9.2% annually over the past 40 years through the end of June, versus 8.5% for long-term government bonds.
  • One of the article’s author, Jason Zweig, calls into question the validity of data used in Jeremy Siegel’s book  “Stocks for the Long Run”.
  • The long-playing Treasury-bond rally seems to have petered out.
  • With Washington pumping out $2 trillion in net new Treasury offerings this year, fear is growing of a vast oversupply that will send prices plummeting and yields—which move in the opposite direction—soaring.
  • Bill Gross, the head of Pimco Total Return fund, predicts that federal debt as a share of gross domestic product, now 45%, could balloon to 300% over the next 10 years.

What does this mean for the income investor? At the macro level, not much. Our investing strategy should not be swayed by the latest headlines.  Headlines are designed to incite two emotions – fear and greed. Acting on these emotions will often lead you to do just the opposite of what you should be doing.

Should We Give Up On Stocks?

Not hardly. Consider what it took for bonds performance to “equal” equities. A decline in the world’s economy and equities not been seen since the Great Depression, coupled with a bond rally driven by the lowest interest rates in generations. In short, equities fell to the level that bonds ascended to. Both stretching what was previously considered “normal.”

Should We Give Up On Bonds?

Conventional wisdom would tell you that bonds have only one direction to go, down.  However, if you have followed your asset allocation model, you are likely close to where you need to be allocation-wise and if bonds begin to fall, it will create opportunities to buy at lower prices with higher yields. If you are not fully allocated, like many of us, a planned and steady movement over time will allow you to enjoy the effects of dollar-cost-averaging.

Currently, I am under allocated in bonds and it is my plan to steadily purchase bonds each month until my allocation is in line. To do otherwise would be a form of market-timing, which is contrary to my investing strategy.  My bond preference is for intermediate and longer-term issues. Here are some bond funds that I have either purchased or am considering:

iShares Barclays Aggregate Bond (AGG) – Yield: 4.28%
The Fund seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the United States investment grade securities markets as defined by the Barclays Capital U.S. Aggregate Index.

Vanguard Long-Term Bond ETF (BLV) – Yield: 5.37%
The Fund seeks to match the investment performance of the Barclays Capital Mutual Fund Long Government/Corporate Index.

Vanguard Intermediate-Term Bond ETF (BIV) – Yield: 4.55%
The Fund seeks to track the performance of the Barclays Capital 5-10 year Government/Credit Index. This index includes U.S. Government, investment-grade corporate, and international dollar-denominated bonds with maturities between 5 and 10 years.

iShares iBoxx $ Invest Grade Corp Bond (LQD) – Yield: 5.49%
The Fund seeks investment results that correspond generally to the price and yield performance of a segment of the U.S. investment grade corporate bond market as defined by the GS $ InvesTop Index.

iShares Barclays 20+ Year Treas Bond (TLT) – Yield: 4.11%
The Fund seeks investment results that correspond generally to the price and yield performance of the long-term sector of the U.S. Treasury market as defined by the Barclays Capital 20+ Year Treasury Index.

Longer term bonds could see significant price declines as interest rates rise to, or exceed, historical norms.  Before making any investment decision you should consult your financial adviser and understand the risks involved.

Full Disclosure: Long AGG, BLV, LQD. See a list of all my income holdings here.


6 Responses to “Bonds: The Next Bubble to Burst? *”

  1. Best of luck, but bonds have been in a long-term bull market for about 28 years. The previous bear market was from 1949 to 1981, or about 32 years.

    I’m not plumping for market timing when I note this, nor an I arguing with your asset allocation advice. Even though bonds turned in ’49, if memory serves me correctly, bondholders did all right in the next fifteen or so years. Of course, that was during an era when the budget was expected to be balanced over a whole business cycle: deficits in bad times were expected to be cancelled out by surpluses in good.

  2. TMT says:

    Do you risk weight your bond portfolio, trying to ladder some of the duration risk?

    Also I noticed the TIPS were not on your list. Have you been looking there?

  3. TMT: Now, I am only buying bond ETF. I have looked and am still considering TIPS. Current results have underperformed, but I am also looking at them from a longer term perspective.

    Best Wishes,
    D4L

  4. TMT says:

    I understand about the TIPS.

    As for duration, if you look at the Vanguard website you can see that BLV has an avg maturity of 21.5yrs & avg duration of 11.6 yrs while BIV has avg maturity of 7.6yrs and Duration of 6.3 years.

    This tells me as interest rates begin to rise BLV is going to decrease in price a lot quicker than BIV.

    From your comment it does not sound like you take this into consideration when you buy a bond ETF.

  5. TMT: You are exactly correct about BLV falling faster when the rates begin to rise. I suspect, but haven’t tested it, that BLV will have higher price volatility than BIV, while BIV will have higher income volatility. I am looking for more income stability than price.

    Best Wishes,
    D4L

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