The bond component of your portfolio plays an important role in asset allocation. With lower volatility, bonds help smooth the ride. Today’s low interest rate environment gives rise to challenges in bond investing. The Constancy Model Portfolios use a selection of bond funds to address these needs.
For your allocation to bonds, I suggest three categories of bond funds and specific funds for each. Before we go there, it is important you understand the basis for my selection. So, here is a quick overview of bond investing and the role your bond investments should play in your portfolios.
Bond Investing 101
Bonds are more clear-cut investments than stocks in the sense that the cash flows are defined by contract. The cash flows include the interest payments or “coupons” the borrower is contractually obligated to pay at regular intervals and the final principal repayment.
And yet bond investing in practice is in many ways more complicated than stock investing.
- Treasury bonds and corporate bonds are the most well-known categories of bonds. However, there are in fact many “sectors” to the bond market, as there are a variety of different types of issuers. Bonds in different sectors have different attributes, which result in varying degrees of interest rate and credit risk (see next bullet points). Major bond market sectors include:
|U.S. Government Bonds||U.S. Treasury and Federal Agencies (e.g. FNMA, FHLMCA, GNMA)|
|Municipal Bonds||State and local governments and authorities|
|Overseas Government Bonds||Overseas governments and authorities|
|Mortgage-backed Securities (MBS)||Bonds packaging mortgages issued by banks on residential and commercial properties|
|Investment Grade Corporate||Companies of medium/high credit quality|
|High Yield Corporate||Companies of low credit quality|
- Bonds have interest rate risk. In the simplest terms, as interest rates rise, bond prices fall (and vice versa). Interest rate risk—the amount a bond price changes from changes in the general level of interest rates—increases the longer the “term” or “maturity” of a bond (the number of years until the principal is paid back).(1)
- Bonds have credit risk, which is the issuer’s ability to make all the payments under the original terms of the contract. Bond prices will move based on changes (real or perceived) to an issuer’s credit profile. So, evaluating credit risk in bonds is analogous to analyzing earnings in stocks. Ratings agencies (S&P, Moody’s, Fitch) assign ratings to many bonds based on their analysis of a borrower’s credit risk, but this is no substitute for bond managers’ own analysis and judgment, which are reflected in bond prices. The ultimate credit risk is the potential for an actual default on the bond obligations. Interestingly, bonds with more credit risk are generally less sensitive to interest rates, all else being equal (including maturity).
- In some sectors, liquidity and price transparency for individual bonds is significantly less than that for stocks. The 10-year Treasury bond is the most liquid bond market. And corporate bonds of large issuers and lower credit risk tend to trade more actively as well. But in general bonds trade less actively than stocks. There is no exchange on which bonds trade. It can thus be more difficult to locate a counter-party and thus get a good price when it comes time to buy or sell a bond. For bond funds, this can be problematic in periods when they have high subscriptions (with need to buy bonds) or redemptions (with need to sell bonds).
- Individual bonds typically have higher prices than individual stocks, making funds (pooled investment vehicles) all the more important for the average investor requiring a diversified bond portfolio. Individual bonds are typically priced in $1,000 increments.
What We Want Bond Funds to Accomplish
My recommendations for the bond allocation in Model Portfolios take these features of the bond market into account, along with several other requirements:
- Your bond portfolio must serve the important role it is meant to play in asset allocation, as I discussed in the Diversification without Complication section. I expect bond returns to be lower than stock returns over the long-term. But the bond portfolio can help smooth the ride if it has lower volatility and experiences price changes in different ways and at different times than your stock portfolio. So, your bond portfolio should be designed to be likely to do this. The bond sectors that historically have exhibited lower volatility and less correlation to stocks have been those with the highest credit quality: (a) government bonds in particular, and (b) investment grade corporate bonds to a lesser extent.
- As noted in the video on Coping with Today’s Low Interest Rate Environment, low interest rates are the distinguishing feature of the current investment landscape. This gives rise to special challenges in bond investing today. Bonds do not generate the level of income today that they have typically provided. Additionally, as interest rates have fallen for over 30 years, bond prices have gone up, providing a source of return. With rates very low—approaching zero in some sectors and maturities—such gains are and will be increasingly hard to come by. Finally, following from this last point, if rates were to rise from these historically low levels, bond prices in general will fall. Given these conditions, we believe a common-sense approach to bond investing today includes caution with respect to taking interest rate risk. This suggests bond funds that either (a) invest in bonds with intermediate maturities, which means bonds that will reach their term in three to ten years(2), or (b) invest in floating rate loans, which means the coupon will increase as prevailing interest rates rise.
- Last but not least, the investment principles I emphasize throughout this site apply equally importantly to bond investing:
- A long-term perspective, putting volatility and current market conditions into this context
- Common-sense, fundamental criteria in bond selection, adhering to a valuation discipline above all
- Caution and humility with respect to forecasting, which with bonds includes not attempting to forecast changes in interest rates
- Low fees, reflective of the value-add of the investment selection process
These principles and criteria are particularly important in arriving at selections of specific bond funds.
Putting all of these objectives and criteria together, I adopt a bond portfolio allocated into three buckets within the Model Portfolios.
1. Government Bond Fund
- Greatest diversification benefits alongside a core stock portfolio. Increase in value in poor economic climates, as interest rates decline.
- Fund holdings: mix of U.S. Treasury bonds and bonds issued or backed by federal agencies guaranteed (explicit or implied) by the U.S. government. No credit risk. Highly liquid bonds.
- Intermediate-term maturities, so as to mitigate interest rate risk. No attempt to forecast future rate changes.
- Minimize fee, given no value added through credit analysis.
|Name (Ticker)||Net Expense Ratio||Assets in Fund ($mm)||Holdings||Average Maturity/ Duration(2)||Benchmark|
|Vanguard Intermediate-Term Government Bond ETF (VGIT)*||0.10%||$1,400||Treasury, Agency||5.6/5.2 years||Barclays US Government Bond (3-10 Year Component)|
|Fidelity Government Income Fund (FGOVX)||0.45%||
|Treasury, MBS, Agency||6.8/5.2 years||Barclays US Government Bond|
|DFA Intermediate Government Fixed Income Portfolio (DFIGX)||0.12%||$3,800||Treasury, Agency||7.6/6.3 years||Bloomberg Barclays US Government Bond Index|
Data as of December 2016. Source: fund companies’ websites, including Fact Sheets and Prospectus. *This same portfolio is also available as a mutual fund, the Vanguard Intermediate-Term Government Bond Index Fund (VSIGX), at the same fee, but these “Admiral Shares” require a $10k minimum.
I provide several options, depending on whether or not you use an adviser and as your brokerage firm may have arrangements with certain fund companies that may lower your all-in costs, in particular transaction (buying and selling) costs, for one of these funds. The Fidelity Government Income Fund carries a higher fee than an ETF, though it is low relative to fund peers. And this fund incurs no transaction fees for those with brokerage accounts at Fidelity. It also is unique in investing in mortgage-backed securities in the portfolio, which adds further diversification.
2. Investment Grade Corporate Bond Fund
- Higher income from credit premium above risk-free government bonds, but still low risk of capital loss.
- Fund holdings: bonds issued by companies with medium/high quality credit profiles, in a variety of industries. Highly liquid bonds.
- Rules-based funds exercising fundamental credit and valuation discipline in bond selection. Low fee relative to fund peers.
|Name||Net Expense Ratio||Assets in Fund ($mm)||Holdings||Average Maturity/ Duration(2)||Benchmark|
|Vanguard Intermediate Corporate Bond Index (VICBX)||0.05%||$1,586||US$ Corporates||7.3/6.1 years||Bloomberg Barclays US 5-10 Year Corp Index|
|DFA Targeted Credit Portfolio (DTCPX)||0.20%||$344||Investment Grade Corporates (emphasis on A+ through BBB-)||3.6/3.3 years||Bloomberg Barclays Global Aggregate Credit 1-5 Years (hedged to USD)|
|FlexShares Credit-Scored US Corporate Bond Index ETF||0.22%||$96||US$ Corporates (US stock listing 84%)||5.5/4.7 years||Northern Trust Credit-Scored US Corporate Bond Index|
|SPDR Barclays Capital Issuer Scored Corporate Bond ETF||0.06%||$46||US$ Corporates (includes overseas stock listings)||10.8/7.1 years||Barclays Issuer-Scored Corporate Index|
|Invesco Power Shares Fundamental Investment Grade Corporate Bond Portfolio ETF||0.22%||$126||US$ Corporates (all US stock listing)||
RAFI Bonds US Investment Grade 1-10 Index
|BlackRock iShares Edge Investment Grade Enhanced Bond ETF (IGEB)||0.18%||$73||Investment Grade Corporates||8.6/6.5 years||BlackRock Investment Grade Enhanced Bond Index|
|Goldman Sachs Access Investment Grade Corporate Bond ETF (GIGB)||0.14%||$336||Investment Grade Corporates||10.9/7.2 years||FTSE Goldman Sachs Investment Grade Corporate Bond Index|
Data as of January 2019. Source: fund companies’ websites, including Fact Sheet and Prospectus.
I provide a wide range of options with respect to corporate bond funds, as your brokerage firm may have arrangements with certain fund companies that may lower your all-in costs, in particular transaction (buying and selling) costs. The Vanguard index fund (also available as an ETF) offers the lowest cost. However, all the other alternatives adhere to fundamental credit disciplines, including valuation.
DFA’s approach with respect to bond investing is to target the higher returns (“premiums”) the market makes available with respect to term (number of years until a bond is paid back) and credit (ability of an issuer to honor its obligation). Academic studies show that, with respect to term, expected returns on bonds go up when spreads (difference in yields) are wider between longer dated and shorter dated bonds. Similarly, with respect to credit, expected returns on bonds go up when spreads are wider between lower credit quality and higher credit quality bonds. As discussed in Bond Investing 101, lengthening maturity (term) and taking on lower credit quality (credit) each entail assuming more risk. Intuitively, when we get compensated better (higher spreads) for taking on these risks, our expected returns go up. So, DFA’s approach is simple: vary term (maturity) and credit exposure depending on the compensation being offered by the bond market over time. If spreads between long and short term bonds are low, DFA’s bond funds move away from this additional risk and so buy bonds of shorter maturity (and vice versa). If spreads between low and high credit bonds are low, DFA’s bond funds move away from this additional risk and so will buy higher credit bonds (and vice versa). The upshot of this approach is a value discipline.
I include five fairly-new Investment Grade Corporate Bond ETFs, all of which track indices. However, none of the indices are market capitalization-weighted. Rather they are all indices of recent design—often at the request of the fund company—with methodologies to select bonds and construct an index portfolio though rules-based fundamental criteria. These criteria are typically proprietary to the index developer.(3) The upshot of this approach is a valuation discipline—the methodologies select and give greater weight to bonds that offer the best credit metrics relative to their yield and maturity. This is a positive development in the bond fund industry, benefiting investors. It introduces rules-based fundamental selection at a lower fee—similar to the approach we have highlighted with respect to stocks.
The Goldman Sachs Access and BlackRock iShares Edge ETFs, in particular, employ methodologies similar to the profitability/quality and valuation criteria I’ve described. The Goldman Sachs ETF uses criteria to identify bonds with deteriorating fundamentals. The BlackRock ETF uses credit metrics specifically to target bonds of higher quality trading at lower valuations. It screens out bonds with metrics associated with low quality and then, for the remaining, weights more heavily those bonds that appear undervalued.
A final element worth noting is the global approach many of these funds take to bond investing. Doing so simply widens the opportunity set. Term and credit premiums (the levels at which these risks are compensated) at any one time can vary from country to country, depending on local economic and market conditions. With a global opportunity set, bond funds have the flexibility continually to move toward countries where taking on term and credit risk are most highly compensated. The DFA, SPDR, BlackRock and Goldman funds all include non-US issuers, with either dollar-denominated bonds or with currency exposure hedged back into US$s.
3. Floating Rate Senior Loan Fund
- Higher income from return premium above investment grade bonds
- Fund portfolio: bank loans made to companies with lower quality credit profiles; but senior, secured loans so first priority in pay back.
- Interest rate on loans floats: changes with changes in benchmark rates. Diversification versus other bond funds, as protection in the event interest rates rise.
- Actively-managed funds exercising fundamental credit analysis and valuation discipline in loan selection. Low fee relative to active manager peers.
|Name||Net Expense Ratio||Assets in Fund ($mm)||Holdings||Average Maturity/ Duration(2)||Benchmark(3)|
|SPDR Blackstone GSO Senior Loan ETF (SRLN)||0.70%||$773||Senior Bank Loans to High Yield Corporates||5.0/0.3 years||Markit iBoxx USD Liquid Leveraged Loan Index, S&P/LSTA U.S. Leveraged Loan 100 Index|
|First Trust Senior Loan Fund ETF (FTSL)||0.85%||$458||Senior Bank Loans to High Yield Corporates||5.0/0.6 years||Markit iBoxx USD Liquid Leveraged Loan Index, S&P/LSTA U.S. Leveraged Loan 100 Index|
|Fidelity Floating Rate High Income Fund (FFRHX)||0.70%||$9,026||Senior Bank Loans to High Yield Corporates||4/0.3 years||S&P/LSTA Leveraged Performing Loan Index|
Data as of January 2019. Source: fund companies’ websites, including Fact Sheet and Prospectus.
I again provide several options, as your brokerage firm may have arrangements with certain fund companies that may lower your all-in costs, in particular transaction (buying and selling) costs, for one of these funds.
This is an investment area where traditional active management remains critical. In addition to properly evaluating bonds issued by companies that are more leveraged and have lower credit quality, these managers have specialized expertise with respect to the legal terms of such loans. To compensate for this added value, these funds do carry higher fees than the other types of bond funds I’ve recommended. Fortunately, this is one of the areas of the ETF market with actively managed funds, which has made these strategies available at lower fee. The Fidelity Floating Rate High Income Fund is the one active mutual fund that has low fees and doesn’t carry a sales charge (or “load”) for individual investors. This fund has a long, successful track record, though it has had a new portfolio manager since 2013. This fund is large in terms of assets under management, which has advantages and disadvantages. There are less liquidity concerns, as if the fund needed to sell loans to meet redemptions, it has lots to choose from. On the other hand, in needing to invest in many loans, it can be less discriminating.
An approach for those in or nearing retirement
Retirees today face an unusual and difficult challenge. Typically, retirees often had a conservative asset allocation, with a large percentage of the overall portfolio in assets classes with lower volatility, investment grade bonds in particular. In the current low interest rate environment, such asset classes unfortunately provide much less income than they have in the past—very little income in fact. Unless your portfolio is very large, the bond income may be insufficient to cover the amount you have planned to withdraw to meet your living expenses. As a result, retirees now need to consider different approaches, including a greater allocation to stocks, given the higher returns they generate.
To do so prudently, however, your asset allocation design needs to allow for the higher volatility of stock portfolios. An approach we think makes sense is to ensure that the money you need to take out of your retirement portfolio is “locked in” for a period of five years. This way, if the stock market has done poorly as you approach the time for any withdrawal, you will not have to sell stocks at an inopportune time. Rather, you take your withdrawal from your cash and bond allocations, which allows you to wait for the stock market to recover. With a cash and bond portfolio that covers five years of your planned withdrawals, the stock portfolio very likely has sufficient runway to recover, based on the length of past market declines and advances.
To put this approach into action, you can estimate at the dollar amount you plan to withdraw from your accounts to help cover your living expenses each year over the next five years. Your withdrawal needs for the next year are held as cash in your portfolio. The sum of the next four years should be the dollar amount you have invested in your bond portfolio. The remainder of your retirement funds are invested in stocks, up to the recommended stock allocation based on your retirement time frame and investor temperament.
To manage interest rate risk, you can use a mix of bond funds with a weighted-average maturity of less than five years or a “laddered” bond portfolio. “Laddering” means that you have bonds that mature at set times, typically the end of each year. That way you know exactly the cash flows you are going to receive from interest and principal repayment, and changes in bonds’ prices between now and the bonds’ maturities don’t matter. Fortunately, there are now laddered bond funds, which allow average investors to have diversified portfolios of bonds in a ladder. The largest is Invesco’s Bulletshares Corporate Bond ETFs.
(1) Cash flows for both bonds (coupons) and stocks (earnings) need to be discounted back at prevailing interest rates to determine what they are worth today. So, stocks also have interest rate risk. But bonds have more interest rate risk because their coupons are defined, whereas stocks’ earnings are not. So, the relationship between prevailing interest rates (yields) and current price is not as explicit with stocks. For example, rising interest rates are often associated with rising inflation, which can mean higher nominal profits for companies as they raise the prices for their goods and services. The higher earnings can offset some or all of the higher discount rate. This same type of dynamic accounts for why bonds with greater credit risk have less interest rate risk.
(2) Maturity measures the amount of time from today until a bond matures or comes to term, which is when the bond is paid back in full—typically with the return of the original amount borrowed (known as principal)—and the obligation is dispatched. Average maturity of the portfolio is the average of the maturities of the bonds held in the portfolio, weighted by the % that each bond accounts for in the overall portfolio. It is important to know the average maturity of the bond portfolio, because the prices of bonds with longer maturities are more impacted by changes in prevailing interest rates. A standard measure of how much a bond price changes as a result of changes in interest rates is duration. It is a more accurate measure than maturity, as bonds with the same maturity can have specific features that give rise to differences in the timing of the fixed cash flows. Duration can be calculated in two ways, which produce figures that are close to each other. One calculation measures the average time you receive all the cash flows weighted by the size of each cash flow, and so is measured in years. The second calculation measures how much the price of a bond (or portfolio of bonds) will change as a result of a 1% change in interest rates, and so is measured in %.
(3) The two recommended Floating Rate Senior Loan ETFs do not seek to track their indices. Rather, as actively managed funds, they seek to outperform these benchmarks.