Webcast replay: What role should bonds play in your portfolio?
April 13, 2017
Replay and transcript from a recent Vanguard webcast
In this replay of a recent webcast, Bryan Lewis, a Certified Financial Planner in Vanguard Personal Advisor Services®, and Kevin DiCiurcio, an investment analyst in Vanguard Investment Strategy Group, discuss interest rate fluctuations, investing during uncertain times, and valid reasons for changing your asset allocation.
Emily Farrell: Hello, I'm Emily Farrell. Welcome to our webcast on the role of bonds in your portfolio. Today we'll cover how to think about interest rate fluctuations, investing during uncertain times, and valid reasons for changing your asset allocation.
Joining us to discuss this very important topic is Bryan Lewis, a Certified Financial Planner in Vanguard's Personal Advisor Services; and Kevin DiCiurcio, an investment analyst in Vanguard Investment Strategy Group. Thank you both for being here today.
Bryan Lewis: Thanks for having us.
Kevin DiCiurcio: Thank you for having us.
Emily Farrell: Before we get started, I'm going to go through two quick housekeeping items, and then we're going to get to most of your questions. At the bottom of your screen, there are a few widgets. For technical support questions, use the blue button on the left. If you'd like to read some of Vanguard's materials on tonight's topic, you can find that in the green resource widget on the far right. All right, does that sound good?
Bryan Lewis: Sounds great.
Emily Farrell: All right, great. To kick off our discussion, I'd actually like to start by asking our audience a question. On your screen right now, you'll see our first poll question, which is, "How recently have you changed your bond allocation in response to interest rate increases: within the last 6 months, within the last 12 months, or I have not changed my bond allocation in response to interest rate increases?" So just take a second, answer, and we'll get back to your responses in just a minute.
So, Bryan, Kevin, while we're waiting for that, I thought I'd kick it off with one of the questions, many questions that we got before today's webcast, which I think just shows you that bonds are, obviously, very top of mind for all of us.
So, Bryan, I thought this was a really great one to start off with. Lori from Wisconsin asked us, "What on earth should I do with my money?" I think a lot of us ask that question sometimes. She says, "Stocks are high and going to fall, interest rates are going to rise, so bonds will fall. Help!" All right, can you help?
Bryan Lewis: Absolutely. There's a lot of uncertainty in the markets today. Stocks have done well, interest rates have started to go up, and the Fed's indicated that they may potentially increase rates a few more times this year. So what's the impact on fixed income or bonds? And the truth be told, really nobody knows for sure, right. There's no guarantees with even this is even going to happen as far as with rates going up. The question I get frequently is, "What do I do with all this uncertainty?"
And, really, if you follow Vanguard's four key principles when it comes to investing, we believe over time it could increase, or at least the potential to increase the likelihood that you're a successful investor. So in order to answer the question what should you do, you first have to have a plan or a strategy, right? You need to be able to clearly define your goals. Examples include, are you saving for retirement, your child's education? And then once you're able to clearly define those goals, you can start focusing on actually building the portfolio.
Right, you're going to first start with a target asset allocation, which is the percentage between stocks and bonds and cash. Then once you determine that allocation, you can start focusing on actually building the portfolio. Vanguard encourages you to focus on using low-cost and balanced mutual funds.
The last piece to this, which is a very important component, is discipline. You need to be able to avoid the temptations to market-time or chase performance. You need to reevaluate the portfolio throughout the year, maybe once or twice, look to see if you have to rebalance the portfolio, and you need to save. You need to save as often as you can. And over time, if you follow this, we do believe you're going to increase the chance of at least being a successful investor.
The question becomes, you know, different sides of the equation, you could have an investor who's all cash and a lot of uncertainty in the market, you're concerned, investing is inherently emotional, and, over time, nobody knows, as I mentioned. And the other side of the equation is somebody who's fully invested, what do you do? And, again, it comes all back to the strategy and the plan that you put together and reevaluating your current portfolio relative to your target asset allocation.
And for those in cash, you could certainly look to maybe move the money over the next few months versus, say, over the next few years because even though you're not in the market, you're still exposed to risk in a different kind, which is your shortfall risk, which means over a long run if you're not getting the growth, you may fall short of meeting your objectives. You also could fall short when you look at inflation risk. Right, you're not earning much, say, in cash investments.
And then those who are fully invested, again, back to your target allocation, you want to make sure you're within 5% of your target at all times. And for somebody who's potentially within that range, you may not have to do anything, but for somebody who's drifted from that, it may present an opportunity to rebalance the portfolio. But it has nothing to do with trying to time the market and chase returns because, again, nobody knows for sure.
Emily Farrell: Right. And I think it's, actually, a very good level-set for our conversation today; and I think that last principle, discipline, is what maybe we're going to be kind of honing in on, whether deliberately or not, because when there is uncertainty and emotion, that's kind of the hardest part for, I think, all of us.
With that, actually, our first poll results are in. So the question, as you probably remember, is, "How recently have you changed your bond allocation in response to interest rate increases?" So about 20%, just under 20%, said within the last six months, just over 6% said within the last year, and 75% "I have not changed my bond allocation in response to interest rate increases." So I think that's kind of what we want to hear, right, from Vanguard investors?
Kevin DiCiurcio: Yes, absolutely. I mean 75% is a great number. We want you to maintain the discipline, stick to your plan. It's not surprising to see 20%. Potentially, they had themselves in a position where they were taking on too much interest rate risk, and it gave them an opportunity maybe to realign their portfolio to their proper risk tolerance.
Emily Farrell: Right. And, again, I mean we're not saying, for example, that you can't revisit it. Exactly what you were just saying, Bryan, it's maybe don't make a rash decision based off of anything like interest rate increases.
Bryan Lewis: Absolutely.
Emily Farrell: So we have another question for you in the audience, and right up on your screen right now is, "What percentage of your portfolio is currently allocated to bond investments: less than 20%, between 20% and 40%, between 40% and 60%, or greater than 60%?" So I think that'll be kind of telling in terms of maybe where our audience is at. So just take a second, answer, and we'll get back to that in a second.
So I have another pre-submitted question that I wanted to get to, and Jerry from Oregon asked a question that many, many of you are interested in. He asked, "As interest rates are imminent, what kind of strategies take place in Vanguard's bond department to protect principal and improve yields?"
Now given the interest, and I hope you guys don't mind, but we called in another expert. We thought we'd bring in Vanguard's Gemma Wright-Casparius. She's a principal and senior portfolio manager in Vanguard's Fixed Income Group. Gemma?
Gemma Wright-Casparius: Hi Emily. Vanguard's approach to managing through rising interest rates really have three key and very important strategies that are utilized by all portfolio management teams across the complex. One is we manage our overall duration. Why is that important? Well, the fund's duration is a measure of its sensitivity to interest rate movements. So, for example, if a fund has a five-year duration and interest rates move up by 1%, the fund's principal return would be –5%. If I manage to shorten that to 4.8 years, and we have a 1% increase, then the return would be –4.8%. It's a very powerful tool.
The second is yield curve management. Not all maturities of all bonds in the fund perform the same way. They don't rise exactly in parallel, and it's very important to deploy strategies that can capture those particular movements. So, for example, if the Federal Reserve is raising short-term interest rates, we would expect zero- to five-year maturity bonds to underperform longer-dated maturity securities, and we might deploy strategies in the fund where we don't own as many of zero- to five-year securities as we did prior to the interest rate increase.
Finally, bond selection. Bond selection is a strategy we deploy in rising and falling interest rates, but it's very powerful in rising-interest-rate environments. And the reason is even for the same maturity bond, two bonds may not perform exactly the same. As yields rise, prices fall. One bond security's price may fall more than the other. We look for return opportunities in the marketplace and will add, if we think there's good potential return, the security whose price has fallen more than the other security.
Emily Farrell: I think that was a really great overview from Gemma. I know I often get very confused by bonds, and I think she gave us a really good intel, kind of behind-the-scenes look at what our Fixed Income Group is doing.
Kevin, anything to kind of add to what Gemma said?
Kevin DiCiurcio: Certainly. It's good to get Gemma's point of view, by the way. I would like to first just start by stating the obvious, that she's describing a process that they would perform on the actively managed bond funds. Index funds will still have the stated objective of tracking their benchmarks as closely as possible.
But I would like to key on a couple items that she mentioned to help clear up any confusion our viewers might have. And the first thing that she mentioned is talking about shortening duration. What does that mean? She defined duration for us. Duration is a bond or a bond portfolio's price sensitivity to changes in market rates, and she talked about shortening duration. And shortening duration is really just lowering the interest rate exposure.
And they can do this in a few different ways in the Fixed Income Group. And the one thing you should realize is that each bond in a portfolio is going to contribute a certain amount of duration. And all those bonds roll up, and they'll total that total duration that she's referring to. So one of the things that they could do is really just buy shorter-maturity bonds, and each bond's going to contribute less duration, and you're going to bring your total interest rate sensitivity down from what she described.
Now you don't always have to trade bonds to do that. There's certain derivatives, types of things in the market that you could do using interest rate swaps, Treasury futures, but there's a lot of different techniques you can use to lower that interest rate sensitivity.
The second point, I think, that she made that's, I think, important to clear up is yield curve management. What is yield curve? What is she really referring to? The yield curve management or the yield curve itself is really a term structure of market interest rates. The curve's usually built looking at government bonds, default, risk-free bonds. So a U.S. Treasury yield curve is really just the visualization of yield levels over bonds from maturities having one year to maturity, which is really the short end of the year yield curve that we talked about and then maturities out to 30 years left to maturity, and that would be the long end of the yield curve.
So really just kind of connecting the dots. If the one-year Treasury is yielding 1%, 5 years yielding 2%, 10-year 2.5%, 30-year yielding 30, that's your yield curve. And the process that Gemma is describing is that duration tells you your price sensitivity to a parallel change in interest rates. In the real world, we rarely see the yield curve all move in the same direction at the same time because parts of the yield curve react differently to monetary, economic variables.
So the example that she provided was tightening of monetary policy by the Fed. She is suggesting that the very short end of the yield curve might move differently than longer-term yields, and they can position accordingly. And they can position accordingly and also target a certain level of duration as well.
Emily Farrell: So I think at a minimum, I'm going to say thank you for demystifying some of these terms to you and to Gemma.
I'm going to pause right there because our second results are in. And as you recall, we asked our audience about the percentage of bonds in their portfolio right now. And interesting, so kind of a little bit of an equal split here. So less than 20%, 32% of our viewers; between 20 and 40, about 35% of our viewers; between 40 and 60, a little more than 26% of our viewers; and just over 5%, about 60% or greater. So what does that tell you?
Bryan Lewis: Well it sounds like there's certainly a wide range. And as far as when I talk to clients, and we go through a lot of this, especially when rates have been low, the temptation is to get out of bonds and go into maybe dividend-paying stocks or equities. And to me it's not that surprising.
Emily Farrell: Kevin, anything to reflect on?
Kevin DiCiurcio: It's probably a wide range of ages of our viewers—
Emily Farrell: That's a really good point.
Kevin DiCiurcio: —which is fantastic to see. I mean you would expect lower bond allocations. For those really early in the accumulation phase, maybe 20, 30 years old, might have 20%. And then 5% of that population with a heavy allocation of bonds, so it's a good range of viewers, I think.
Emily Farrell: All right. Well, just a reminder to our viewers, you can definitely send the questions as we go. I have a ton of questions that you submitted in advance. So let's kick it off with another one of them. Joe in Spring, Texas, he asked, "If rising interest rates hurt bond prices, then why should I buy bonds when interest rates are increasing?" All right, pretty simple, Kevin.
Kevin DiCiurcio: It's simple, but the ultimate paradox, I think, for fixed income investors. As fixed income investors, we really do want higher yields. Higher yields mean more income, higher potential expected returns in the future, but the process from getting to low yields to high yields means negative price movements and negative price returns for the bonds that you already hold. So how do you reconcile that?
And, you know, we do it in a couple ways. We certainly hear about the concerns on rising rates very frequently. So we think of it in a few different ways. The first is that the yield curve that I described already contains information about the future market expectations for future interest rates. And when the yield curve is upward sloping, it tells you that there's already a general degree of rate rising that is expected by the market. So, you know, if you're trying to get fancy and time the market and say, "I'm going to get short duration or lower my interest rate exposure buying shorter bonds," you know, shorter bonds will outperform longer bonds only when rates rise faster than expected. Longer-term bonds will outperform shorters when rates don't rise as fast as expected.
It sounds very tough to do in practice, and it is. And if I'm being completely honest, the future interest rate movements that are priced into the yield curve have a very poor predictive power in the future as well. It's just another reason why we think timing things is very difficult.
I started my career, actually, in fixed income in 2009, and I can recall at least three other occasions where financial news market commentators are telling us that we're going to get the sustained rise in interest rates. And each time, yes, rates rose a little bit, and they kind of settled lower. So it just demonstrates how really it is difficult to time these sorts of things. So we really encourage clients that have intermediate-term time horizons to really focus on the total returns of your bond portfolio, and the total returns include both the price return and also the income return.
As interest rates rise, you will experience short-term capital losses. The reason you experience short-term losses is because as new bonds are issued at those higher coupons or higher rates, the bonds you hold to be attractive in the marketplace, the price has to decline. You're holding a lower coupon; the price has to decline so that the yields are comparable.
And so as, you know, you take the short-term capital hit, and as higher coupons start replacing the lower coupons in your portfolio, over time those coupon returns, those income returns start offsetting those short-term price movements. So we see over five-, six-year horizons, you can really look through those capital losses and focus on the positive higher income that you're generating.
Emily Farrell: Okay. So, Bryan, we actually just got a live question, and I have a stinking suspicion that this might be something that you hear from your clients, and it's a good follow-up to what Kevin was talking about. Mickey asked us, "Since Fed rates are expected to increase, doesn't it make sense to reduce bond holdings and maybe even move to total equities for a more assertive investor?"
Bryan Lewis: It's a great question. So when you start looking at interest rates going up, you know, the Fed, I mentioned earlier, has talked about they may increase rates maybe a couple more times this year. There's no guarantee that actually is going to happen, and we've seen this in the past. How many years have people been talking about interest rates going up, and, obviously, look where we are today. But there's things domestically and abroad that could deviate the strategy the Fed has.
As far as going all equity, it varies. It depends on your personal risk tolerance. So a lot of investors cannot withstand the volatility or the price fluctuations with equities. I think a trend that we saw for a while, or at least the questions that I get from my clients, is why go into bonds if rates are going to go up? Why not go to a dividend-paying stock or equities where they potentially could make more money? Well, we have to think about the role of bonds. Right? They're there to provide stability.
I think of it as driving a car. You're going down the street. Your foot's on the accelerator. For maybe a younger investor who's far away from retirement, so they have a long time frame, they're going fast versus somebody who's approaching retirement, you're going to apply the brake to slow down. And really the idea with bonds is to add stability. And, of course, they're going to generate some income, but most investors, they go into equities and then they don't realize how volatile they can be. And the risk when you think of successful portfolio construction, it's not always about how much money you can make. It has to do with how much, you know, you're protecting the downside risk as well.
Kevin DiCiurcio: If I could just add to something you said early on.
Emily Farrell: Absolutely.
Kevin DiCiurcio: I think a lot of investors, they hear economic news and know that the Fed is about to embark on a tightening cycle. They're raising the short-term interest rate, and they plan on maybe two more this year, maybe three. And what they think is that that's going to affect the price of all their bonds.
When you have this broad market exposure, we know that those interest rate increases are going to affect yield curve differently. Gemma described that situation. So if you have the broad diversification, you're not getting that parallel move in the yield curve that's hitting all your bonds at once. So the concerns about the Fed hiking short-term interest rates, we don’t necessarily see that playing all the way through the entire yield curve. So keeping the diversification, the broad exposure, we'll talk about international a little bit, these are your best practices to really cover yourself in that sort of situation.
Emily Farrell: So, you know, given everything you've just checked in about, there was a question I noticed right off the bat when we pre-submitted; and I figure it would be a good time to get to it. Ulm from Washington asked us, "How does a bond fund act as a counterbalance to a stock fund?" I think that might be a great place to start, right?
Kevin DiCiurcio: Yes, it's a great place to start. This is the title of our webcast. I mean this is a major point that we want to make today is to talk about the role of the bonds in the multi-asset portfolio. And we brought a couple of charts with us today to help describe it. But before we look at those, I just want to level-set something with the audience. I may, going forward, and I probably have already talked a lot about risk. And I know risk is very personal to people. Typically risk to them might be falling short of your investment goals.
When I refer to risk today, I'm really going to be talking about portfolio risk. And portfolio risk is all about trying to measure the uncertainty of your return outcomes. I might use terms such as volatility, variability, variation. These are really just kind of fancy terms that describe fluctuations in your return portfolio that describe that uncertainty. So I just kind of wanted to—
Emily Farrell: Well, Bryan and I will just call you when you use those fancy terms.
Kevin DiCiurcio: So with that, I really would like to move into the couple charts that we have today.
Emily Farrell: Absolutely.
Kevin DiCiurcio: So the first chart is our volatility chart.
Emily Farrell: And I think if you're watching at home, that should be up on your screen right now.
Kevin DiCiurcio: Great. All right, so here is our volatility chart that we want to show you today. Another thing I should mention is that for an investor with a total return objective, total return is really you want to maximize your return for some unit of risk. So for total return objective investors that have a balanced stock bond portfolio, even if it's a 60/40 portfolio, equity risk is the primary driver of the return variation in your portfolio. So 60/40, it still explains about 95% of your return variation. And in plain talk, that just means that your portfolio moves with the equity market. It's very highly correlated with the equity market.
So we see the use of bonds, investment-grade bonds—sovereigns, Treasuries, investment-grade credit bonds—to serve as that instrument that you can use in your portfolio to really hone in on the level of uncertainty that you're willing to take. Really balance your portfolio's risk with one's own risk tolerance. And that's sort of the relationships that we have on this chart here.
So what this chart shows, going from left to right, is a series of stock/bond portfolios ranging from 100% equities, 100% stocks to 100% bonds. So bonds are being added into the portfolio as you go left to right.
On the vertical axis, what you're seeing here is a measurement of your return volatility in that portfolio going back from 1920s, I believe, '20,'22 through 2015. That's the red bar. The gray bar is going to show you your average returns during that time period. So this chart really shows you kind of the crux of the trade-offs that long-term investors face is that you add more bonds to your portfolio, you add more certainty or less uncertainty to your return expectations, but your return expectations also decline. So it's really balancing these two. But because equity risk is the driver, we feel like the really critical decision is finding that stock/bond mix that gives you comfort so that you can tolerate equity market downturns.
I believe you talked about discipline early. You know, I think it might be obvious that adding bonds adds more stability. What's less obvious is the investor behavior part of that. If you have that stability, you can weather the equity market downturns and, actually, rebalance your portfolio instead of panicking and selling. That would be a much more value-add activity to be rebalancing when equities decline in value.
Emily Farrell: Do you have similar conversations with your clients kind of walking through, whether this chart or not?
Bryan Lewis: Yes, I was just going to mention that this comes up frequently too, as well, is when you see, especially after the election with equities going up, very strong returns, and then you start seeing rates go up, price go down on the bonds, it's tempting to want to shift out of something that's not performing very well and go after something that's giving growth or at least has risen more rapidly.
And truth be told, by the time you start to figure out maybe what you want to do, you miss most of the upside anyway. So trying to time this, most investors, the average investor won't be able to do that well, and professionals can't do it well to begin with. So I think, to Kevin's point earlier, about your asset allocation, that’s going to drive a lot of the risk and return over time. And avoiding the temptation to kind of market time or chase performance is something that I'll partner with clients and reevaluate.
But it all comes back to that plan that I was alluding to earlier is if you maintain that discipline over time, again, you're going to increase your chance in the long run that you could be a successful investor.
Emily Farrell: Absolutely. Yes, and I think it really kind of speaks to just the role of bonds in the portfolio, right?
Kevin DiCiurcio: That's right. We have a second great chart that I think might be a little bit more insightful. Viewers may not have seen something like this before. And we're calling this the bonds as ballast slide. You may have heard colleagues at Vanguard Investment Strategy Group, other parts of Vanguard, talk about bonds being the ballast to your portfolio. Does that mean something different than what I just referred to about stabilizing your uncertainty of your return outcomes?
To me, ballast doesn't mean something different, but what it is, is diversification in practice. The previous slide that we went through talks about volatility over very long periods of time, 1922 to 2015. It's smooth. It's an average experience. We know that assets in the real world, they have time-varying relationships. So what's really important to investors is to know that these bonds provide diversification when I need it most. And we talked about equity risk being the primary driver. You need your bonds to be the ballast when we have steep declines in the equity market. And that's what the second slide is showing us here.
So if we look at this, what we have here is about 22 years of monthly return data, and we're targeting the worst 25 monthly returns of the broad equity market during that 22-year period. Really, we call it the worst decile, worst bottom 10% of equity returns. You could see that's plotted on the far left.
So on average, we're plotting average levels here, average return levels. On average over the 25 worst-performing equity periods, the equity market has lost about 7%. And the rest of the chart, what we're showing is how those other asset categories and asset classes performed during those worst 25 months of equity returns.
What you can see is the only positive bars are investment-grade, either Treasury bonds or aggregate bond indices, muni bonds, indices as well, have provided positive average returns when equity markets suffer steep declines. To me, that's what it means to be ballast. That's when you need your diversification the most. You've got emerging market equities, REITS, it's an equity sector, dividend stocks. These all have a lot of equity risk. They're going to follow the equity market lower for the most part.
And the other thing, people like to reach for yield with high-yield bonds, emerging market bonds. The credit risk in these sorts of investments is such that it's very highly correlated with equities as well. So it's really the investment-grade Treasury bonds, credit bonds that serve as this ballast.
Bryan Lewis: And you also have to look at this way as well is that when I talk to investors and my clients about, you know, looking at this very chart or kind of talking through this is when you look at the, for example, dividend-paying stocks, they're going to pay you the dividend, but they're also going to be very volatile, right? 2008 is a perfect example of that. Even though they might be paying dividends, their principal or their capital return is still very negative in kind of a worst-case scenario. And that's not what you want for bonds, right? You want the bonds to add that stability.
And typically when I look at portfolios of clients that try to reach for yield, you typically see they have large-cap value stocks, so their portfolio is tilted in that direction, which presents a risk. They also lower the credit quality for reaching for yield. And then, you know, when I analyze the portfolio, and we have the conversations and talk through the underlying risk of the portfolio, it's enlightening. And trying to figure out, you know, maintaining that diversification because things are not going to always move in the same direction.
Emily Farrell: Yes. So I mean I think that it is really interesting because we did get a lot of questions, I think, specific about dividend-paying stocks and using that as a replacement with bonds. But I guess the kind of takeaway is maybe buyer beware?
Bryan Lewis: Exactly.
Emily Farrell: All right. We got another live question. I think this is really interesting, Bryan. Hal asked us, "If someone has a lump sum that is earmarked for bonds," all right, so they're already making the allocation towards bonds, "would you suggest dollar-cost averaging, given the likely upward trend of interest rates?" What do you think?
Bryan Lewis: It's a good question. It's certainly a valid question. As I mentioned earlier, maybe one side of the equation investors starting out in cash or lump sum. Typically when you get into, do you do a lump sum, do you dollar-cost average—and for dollar-cost averaging for viewers that don't understand it, it's essentially moving the money in gradually versus immediately—most of our research shows that two-thirds of the time, roughly, you are better off doing a lump sum into the investment.
Our thought is on this is you're better off with bonds because the price doesn't move as much. You're better off getting that invested sooner rather than later. Equities, there's significantly more price volatility with that, meaning, they're going to fluctuate. So if you're going to dollar-cost average, our thought is if you do it, do it on the stock side, not the bond side, because if you look at, for example, some of the bond funds, they only fluctuate by the pennies versus stocks. It's a much more significant fluctuation.
Emily Farrell: Yes. That is interesting because I think I always think of dollar-cost averaging in terms of a question that is related to equity investments, but I guess perhaps you get them quite often when individuals are talking about their bond allocation as well.
Bryan Lewis: Absolutely. And my recommendation to clients too, as well, is that you don't want to manually do the dollar-cost average if you can automate that. Maybe pick a certain time of the month, you know, the 15th of the month, whatever it might be as an example, you're better off automating that versus manually doing it because if you pick a day and you go and look at the market being down, you're most likely not going to invest that money.
Emily Farrell: So take the emotion right out of it, right?
Bryan Lewis: Correct.
Emily Farrell: Makes sense to me. I think I would probably be better off if I had some of that automation as well.
We have another live question. This one actually came in through Twitter. And this is another reminder, in addition to doing it on the platform, you can ask questions via Twitter. Jim asked us, "How should we think about inflation-protection bonds?" Either of you like to take the first shot at that one?
Bryan Lewis: I'll take it.
Emily Farrell: Sure.
Bryan Lewis: So when you start looking at bonds, there's, obviously, several types of bonds. And it very much depends on—and I get back to that point earlier about your plan, your asset allocation. Typically when you look at inflation-protected securities, they could be a good opportunity if there's surprise inflation. So a lot of the time inflation is already factored into the market.
For investors that have more equities in the portfolio, over a long period of time, equities have done a good job of keeping up and surpassing inflation. When you have a more bond-heavy portfolio, you have a concern with inflation, or really more the surprise inflation, that's when inflation-protected securities potentially could be an option, not as a core piece of the portfolio. Maybe complementary. But generally over time, in our view, equities are the best hedge against inflation.
Emily Farrell: Okay, interesting.
Kevin DiCiurcio: Yes, from a research perspective, there's a couple schools of thought here. People talk about hedging inflation risk and are real securities, real assets, or inflation-protected securities a good inflation hedge?
And there's two ways we talked about it. The one is what you described, having high average real returns. You know, over time, equities are going to do the best job at that. They're going to outperform inflation, but that might not necessarily, what people think of as an inflation hedge.
Emily Farrell: Yes.
Kevin DiCiurcio: Other people might think inflation hedging should be, you know, I want my returns to completely covar—, move together with inflation. When inflation is up, I want my returns to be up. And it's very difficult to do, even with inflation-protected securities. Even though the coupon will be, if there's— When inflation is delivered to the market, your coupon on your inflation-protected security will be marked to inflation for you. So what that does is give you a little bit more stability in your real return. I know in our Target Retirement series, we add inflation-protected securities, late-accumulation phase near retirement to really kind of help stabilize in the bond portfolio the real returns a little bit. In terms of inflation-hedging properties, it's still very difficult to do with it because real interest rates, which is what TIPS are exposed to, can be very volatile.
Emily Farrell: Yes.
Kevin DiCiurcio: So even though inflation's up, your real rates might be down, and you don't really know what's going to happen there. But—
Emily Farrell: So I'm going to pause right there because I told you I was going to ask you to demystify some of these terms.
Kevin DiCiurcio: Okay. Yes, sure.
Emily Farrell: Coupon. You mentioned coupon. What is coupon?
Kevin DiCiurcio: Yes, coupon, it's the cash flow you're receiving from the bond. Generally, coupons are paid semiannually. So the coupon works with the price and the time horizon, the maturity of the bond to determine what your actual yield is.
Emily Farrell: Okay.
Kevin DiCiurcio: So the inflation-protected security, to your point, when inflation's delivered to the market that might be unexpected, your principal's going to be changed to reflect that inflation, and your coupon is going to be marked to that. So you get a little bit more stability in your real return.
Emily Farrell: Okay.
Kevin DiCiurcio: And real return, again, is returns over inflation.
Emily Farrell: Okay, all right. So you mentioned correlation earlier in a question. So I want to get back to that because we got a question pre-submitted from Tacoma, Washington. Nicholas is all the way over in Washington, and he asks about bonds seeming more correlated to equities in the past. Does this make them less desirable as an asset class?
So I think I can answer the second part of the question based on some of the things you guys have just told me, but the first part of the question, true?
Kevin DiCiurcio: Not exactly, I would say. The insight is impressive in that this viewer realizes that relationships, asset return relationships are time-bearing. They're not set in time. Your correlation over any number of time period probably has got some fluctuation to it, and you're kind of getting an average correlation, so that's definitely an important insight.
So I did take a look at this yesterday preparing for this, and when you're calculating correlations, there's a couple things that we have to consider. One is what's the frequency of the data that you're using, and now I'm getting pretty geeky here, but what's the frequency?
Emily Farrell: Sorry, we'll make fun of you for it later.
Kevin DiCiurcio: You know, are you using daily returns, using multi-returns? That's one choice you have to make.
The other choice is, you know, what's my sample period? A standard approach that we use in the Investment Strategy Group is, you know, we use monthly return data over maybe a three-year lookback period. So what I did is I looked at the data going back to the 1990s. I looked at broad equity market index relative to various investment grade fixed income indices—the Bloomberg Barclays Agg[regate Bond Index], as well as some of their Treasury and credit indices. And what I found is that the current trailing three-year correlation on monthly data of all those bond indices relative to equities is very close to historical averages. The Barclays Agg, Bloomberg Barclays Agg and the Treasury indices, a slightly negative correlation currently, using a three-year lookback. And the credit indices is slightly positive. Very typical of what we would expect of the diversification properties of bonds.
Emily Farrell: Okay, all right. So we're going to pivot here because I think we just got a great question that just came in. And, Bryan, I think you work with a lot of clients probably in this situation. What should a retiree do to preserve gains if the stock market takes a dive but bonds are also heading down? So, you know, obviously, retirees don't have the time to recoup heavy losses over the years. So Carol asked us that, and, you know, I think with the way equity markets have been, you know, it's something that maybe is on people's minds.
Bryan Lewis: Yes, it's a good question. Partnering with clients and managing their portfolios, it all comes back to that plan I was alluding to earlier, right? You need to have a target asset allocation. So, again, that's the percentage between stocks, bonds, and cash.
So I mentioned this a little earlier as well, is if you're within a few percentage points of your target, so if 50% is your target and you're within 5% of that, then maybe you don't need to do anything. But if your portfolio has drifted over time, that could present an opportunity to rebalance the portfolio. Obviously, you want to be aware of any tax implications. But what you don't want to do is try to time this because you think back to last year. Last year is a perfect example. Early in the year there was a market correction. People were talking about equities going down for the year, and then they rebounded. And then we saw in the summertime Brexit. A lot of people moved to cash, and what did the markets do? They went up.
And then, again, we saw the same thing in November with the election. Markets are very resilient, but, again, nobody knows for sure. You need to remain disciplined. If you can do that and avoid the temptations really to time the market, again, we believe you're going to increase your chance of being successful in the long run.
Emily Farrell: All right, so we're going to take a pause there because we're getting a lot of questions, and I think it's back to some of the terminology.
Before we even started, John had asked us, "I want to understand yield, discount, and interest." All right, so, Bryan, can you walk us through it?
Bryan Lewis: Sure. A simple example of this is, let's say you have a bond, a $1,000 bond. That's par value, meaning the value you might get at maturity. Let's say the coupon rate is 5%, so 5% of 1,000 is $50 a year. Now let's say interest rates start to go up. Instead of 5%, you can now get a bond that's yielding 6%. So if you're the owner of that 5% bond, it's now less attractive because of the, reduced, or the lower interest rate that you have with the coupon rate.
If you go out and try to sell that, because it's less attractive, the price of that bond will be worth less. So instead of maybe $1,000, it's worth $900. So the idea is, and you'll see this with mutual funds as well, is with a bond fund you get hundreds, if not thousands, of bonds. But I think the easiest way to remember the relationship of this is when interest rates start to go up, bond prices will go down. As a result of the price going down, the yield will start to go up over time, so there's an inverse relationship to keep in mind. But back to my example is if rates go down, instead of going up, but if they go down, you could be selling it at a premium versus a discount. So things to consider.
Emily Farrell: Okay, all right. Anything to add, Kevin?
Kevin DiCiurcio: Just that's the bond math. The bond math that he describes, I mean the cash flows are generally certain. You know the price you're paying for it, and you know the time to maturity. I may have misspoken a little bit earlier, but knowing the price, knowing the coupon, knowing the time to maturity, you will know your yield. Conversely, if you know your yield, you know your coupon time to maturity, you can calculate a price.
Emily Farrell: Okay.
Kevin DiCiurcio: All of these have relationships with one another.
Emily Farrell: Okay, great. Thank you for that, and I think it was a good clarification.
Another pre-submitted question from Linda in California. So, Kevin, I think you talked a little bit about term before. We understand the importance of bonds and what portion of our portfolio they should be. We don't understand what percentage should be short-term, medium-term, or long-term, so maybe you could walk us through that, and I think you did kind of touch on something similar earlier.
Kevin DiCiurcio: Maybe, yes. Yes, it's a good question, and if I may just kind of extend the scope for this question a little bit. To me this question's all about construction of bond portfolios.
Fixed income markets present investors with a few different opportunities to add yield compensation over a risk-free rate. I generally think of the risk-free rate as like a three-month T-bill. You have to take risk to earn that compensation.
Emily Farrell: A T-bill is a Treasury.
Kevin DiCiurcio: I'm sorry. Yes, a T-bill is a very short-term Treasury security of very little duration, so no interest rate risk, barely. And it also is risk-free in terms of credit risk because the U.S. Treasury can print the currency to satisfy obligations.
So the T-bill we would consider the risk-free rate. So fixed income investors can do things to earn compensation on top of that. The one is we talked about earlier, taking duration risk, taking term risk. Investors are compensated for that. Another thing is adding credit bonds to a portfolio. You're taking credit risk, but they should have higher expected returns.
Another thing, a little bit lesser known, is taking prepayment risk and purchasing an agency mortgage-backed security. These are three types of investments that are available in sort of a broad market index. The one we reference a lot is the Bloomberg Barclays US Aggregate Index, so that's a great starting point for any investor because you get the balance of a lot of these diversifying investments.
Emily Farrell: So like a total U.S. bond type of portfolio?
Kevin DiCiurcio: That's right. That's right. So it's not just short, intermediate, long. It's really combining these credit interest rates, perhaps mortgage-backed securities, if you have a long-enough time horizon to do that. In terms of the term, I think that really comes down to risk preferences and also what your time horizon is. I can define the term, certainly, a short-term bond portfolio generally contains bonds that have one to five years left to maturity. It's constantly rebalanced monthly to maintain the one- to five-year types. Usually the duration, interest rate sensitivity is around three. Intermediate-term bond funds, five to ten years. Long term, ten-plus.
And, again, if you're thinking as the broad market as your starting point, and you need to tilt, you're going to tilt to shorter maturity securities, you would do that for a couple reasons. One's risk control is the one we would see. You know, if you don't have much tolerance for principal loss because you have short-term liabilities that you need to satisfy and you're uncertain when they might happen, that might call for a little bit more principal protection for you to take a shorter duration.
Longer-term securities, the ten-plus, have a lot of interest rate risk, a lot of price volatility. You know, we generally see concentrated exposure to those sorts of securities in insurance portfolios, defined benefit pension plans that are trying to match to some long-term liability.
Emily Farrell: Okay, so there's a little bit of like individual preference and individual situations that are wrapped up in this decision, right?
Bryan Lewis: Absolutely. I was just going to mention that as, when you start getting into applying that to the portfolio for an investor that might need the money in two years, you're not going to want to go out and buy an intermediate- or a long-term bond or a bond fund. You want to look at the duration or the average duration of that, and you really want to match that to your investment horizon. So let's say you have a horizon of maybe five years. You could go out and buy a diversified bond fund that will give you a similar, you want to look at the average duration of that to kind of match that. So if you have a shorter investment horizon, you don't want to go out and buy an intermediate- or a long-term type of bond or a bond fund.
Emily Farrell: Yes.
Bryan Lewis: Because the idea is you want to immunize the portfolio, right? You want to look at the time frame for that money and make sure that your investment horizon is equal to if not longer than the average duration of the bond that you're looking at.
Emily Farrell: And really to some other questions that we had gotten before in terms of investment horizon, now how often does that have to do with age? I believe that we got a question from Burton, actually, just asking about age influencing bond allocation.
Bryan Lewis: Yes, so what I commonly hear is "Should I have my age in bonds?" I think it's just—
Emily Farrell: Don't worry, I won't ask either of you what your bond allocation is.
Bryan Lewis: When you really look at it, there's no special formula. So if you're an 80-year-old, the idea is that you should have 80% of the portfolio in bonds or if you're a 20-year-old, you should have 20% of the portfolio in bonds. When you look at the individual portfolio level, you'll find that it doesn't always make sense because it could be more aggressive or more conservative than really that individual's risk tolerance.
So if you're a 20-year-old investor saving for retirement that might be 40 years down the road, somebody with more of an aggressive risk tolerance might have 0% in bonds. So it very much depends, and it certainly depends on kind of the cycle that you're going through from an accumulator to a pre-retiree or to a retiree.
Emily Farrell: Gotcha. So this is probably one where it wouldn't even really be a rule of thumb.
Bryan Lewis: Correct.
Emily Farrell: Okay, interesting. So we demystified more content around bonds. So I got another live question from Twitter, and I think it's a little bit more about bond composition. So Rich asked us, "Within the bond portfolio, what's the role for bond index versus actively managed bond funds?" Kevin, do you want to start?
Kevin DiCiurcio: Sure, can you repeat the question?
Emily Farrell: Sure; so Rich asked us, "Within the bond portfolio," so, obviously, we have a bond allocation, "what's the role between bond index funds or bond actively managed bond funds?" So really just an index versus active type of question. Back to basics.
Kevin DiCiurcio: We get this question a lot. We get this question a lot, and we are building out our research in this regard. To us this is an ability and willingness to take active risk and understanding what comes along with that is, I think, the primary consideration.
My boss tends to say, my manager tends to say if I know nothing about you, market cap-weighted exposure to stocks and bonds according to your risk preferences is a great starting point. That gives you a lot of certainty around the market portfolio. You don't feel like—
Emily Farrell: So index essentially?
Kevin DiCiurcio: Right, indexing is going to give you a lot more certainty.
Emily Farrell: And that's kind of similar in equities or bonds, right?
Kevin DiCiurcio: That's absolutely right. So the choice to go to active requires a willingness to take on the uncertainty that comes with selecting a manager and the positions those managers are going to take.
You know, we know there's still, active management's very popular because a little bit can really go a long way. A small amount of outperformance compounded over a long period of time can really improve wealth outcomes for an investor. It's very difficult to do. We know on a count basis, whether it's a stock or bond, whether you're looking at stock or bond fund managers, we think only one in four, one in five actually outperform their style index.
So the probabilities to outperform are challenging to begin with because for every dollar that wins, there has to be a dollar that loses. So once you consider the cost of the management fees, most managers are going to underperform their benchmark. So it's really can you tolerate the underperformance risk for the ability of outperformance?
Bryan Lewis: And I do want to take this question a step further too as well because I think it's helpful. When I look at investors' portfolios, one of the things that usually comes as a highlight is the bonds, whether you have index or active. Now let's say you start. You have your plan. You have your asset allocation, again, your stock and bond target. And you're deciding, you know, the bonds that you want to have in the portfolio. You also have to look at what's called asset location, which is really where you're going to start to own the investment. A lot of people overlook that.
So, for example, whether you're an index bond or an active bond, Vanguard generally believes that you should own the fixed income or the bonds within a tax-deferred account. So, for example, a 401(k), especially for investors that might have a mix of different accounts, you have your 401(k) or an IRA. A taxable account example would be a joint account.
Emily Farrell: Correct, yes.
Bryan Lewis: Ideally, you'd want to start and shelter that income into a tax-deferred account. So, for example, if you own a taxable bond that's going to be paying ordinary distributions, you're going to be paying ordinary income tax on that income, so we'd rather shelter that into a tax-deferred account. And looking at, say, a stock index fund, preferably in a taxable registration, just because of the taxability, and usually with an index fund, as an example, they don't typically pay out, although it's possible, capital gain distributions. But, again, long story short is even though you're starting to choose the investments, you also have to look at the accounts that you're going to be applying those investments into.
Emily Farrell: Yes, I think it's a really important addition. Asset allocation, as we started with, and a lot of that construction of the overall portfolio, but asset location is probably equally as important, right?
Bryan Lewis: Absolutely.
Emily Farrell: So we're getting a ton of questions. Real quick, and I just want to make sure that I point out that a lot of you are asking about advice and the group that Bryan works in, which is Vanguard Personal Advisor Services®, and if you click on that green resource widget at the bottom of your screen, you can find information all about it. You can also find additional resources that might help you walk through some of the points that we've talked about in today's webcast.
Emily Farrell: A really good point to tie it off. So I have another question about bond type, if you will; and Renee asked us about the role of U.S. bonds versus developed market bonds versus emerging market bonds. And I think another way to put this, if I may, Renee, is the role of international bonds in a portfolio, right?
Kevin DiCiurcio: Yes, absolutely. I would love to take this question.
Emily Farrell: Sure.
Kevin DiCiurcio: We've done a lot of research in the Investment Strategy Group on this topic because I think it's been within the last five years that we've actually added currency-hedged, international aggregate bond market exposure to our target-date funds. I think we added it to the funds five years ago, and within the last couple years, we've increased the exposure to 30%. So the research—
Emily Farrell: And using target-date funds is kind of a proxy for a portfolio, right?
Kevin DiCiurcio: Yes, target-date funds, it's our transparent, single-fund solutions that has the proper balance, proper diversification. That is a great starting point for most retirement savers.
But the research that went into that determination is really one, it's a story about diversification. Again, we are talking about currency-hedged international aggregate bonds here. And we talk about those clients a lot, and I've gotten a couple questions over the last couple of years. A couple things that come up is, well, this index, this portfolio is longer duration than the U.S. aggregate market, so why would I want to be in that? And the second thing is there's such low yields in the international marketplace, why would I want to be in that? So I can help address a couple of those questions today.
And the first one is the one really about the diversification properties. I tell clients that in this regard, longer duration or more price sensitivity to interest rate changes does not necessarily always mean more risk. And the reason being is duration from an international market perspective is a weighted average exposure to a lot of different countries' yield curves. And those countries are like European Union, United Kingdom, Japan, Australia, they all have independent monetary policies and independent economic processes from one another, so you're really getting a lot of diversification just by combining all those. And it plays out in, again, the volatility and the uncertainty. The international aggregate currency-hedged portfolio actually exhibits lower volatility than the U.S. market does. And the reason is, you look at the U.S. Aggregate Index, and all of your interest rate exposure is to the United States yield curve. Lower duration, more return volatility. So we do think there's a lot of value to building a global bond portfolio that combines U.S. and international in a currency-hedged way.
Emily Farrell: Right, and I'd say cost is also an important factor, and I think I learned that from your group just recently in terms of international costs or the cost of international investing has decreased over the last few years, right?
Kevin DiCiurcio: That's right. I don't have the numbers with me.
Emily Farrell: I think we have a paper on it.
Kevin DiCiurcio: Okay.
Emily Farrell: Go to vanguard.com, right?
Kevin DiCiurcio: Fantastic, yes.
Emily Farrell: All right, so I want to go back to a question that had been pre-submitted, and this is something that I've thought about, I remember, in the past. And Katherine from Houston, Texas, asked us, "Explain the advantages or disadvantages of investing in bonds versus bond funds." Bryan, do you get this question from clients?
Bryan Lewis: Yes. So there's a couple of things to think about. So with bond funds, you could, depending upon, there's obviously a lot out there. You could pick a bond fund that has hundreds if not thousands of bonds within that fund. So you're getting diversification; you're getting exposure to different issuers, credit quality, maturities all through a single fund potentially. And then comparing that to say an individual bond, you'd have to have a significant amount of capital, personal, when you think of your investable assets to replicate that diversification that you would get through a fund, which most investors don't have.
Next is when you start looking at the portfolio construction and liquidity of it, so it's very easy to pick up the phone or go online to ask for a partial liquidation. So, for example, you need $3,000 and you have a fund, and you can easily get that money fairly quickly. When you compare that to an individual bond, let's say a bond ladder, you have to—
Emily Farrell: And what do you mean by a bond ladder?
Bryan Lewis: When you look at having a significant amount of individual bonds that are set to mature, let's say, on a monthly basis. When you compare it to a bond ladder, you have to worry about or have to go out and find a buyer for my bond, which can take time, and you have to worry about the actual portfolio construction piece of it, meaning I just sold an intermediate-term bond fund, individual bond. Now I have to worry about replacing that into my portfolio to maintain the same diversification that I had previous to that. So most investors don't do that. It's a lot of time potentially that you have to allocate to that.
Next is cost. So with a mutual fund, you have the expense ratio, which is the ongoing cost to run the fund. When you compare that to, say, a separately managed account, so say it's a firm managing this bond ladder, it's generally going to be lower than what you'll experience within that individually managed account.
The thing a lot of investors, when I have this discussion with my clients, overlook is the transaction cost when you have an individual bond. So let's say you go out and you want to buy a bond. There's what's called a bid and ask spread, which is basically the difference between what somebody is selling it at and what you have to pay for it. That can be very widespread when you have a very, let's say it's a $10,000 purchase. It's a very small transaction compared to a mutual fund where you typically could have $1,000,000 or more on a single transaction, so that spread, that cost is very, very small.
And then the last piece is what's called a control premium, meaning you have more control over an individual bond portfolio than you would on a bond fund. So let's say you want to go into a bond fund, and you might need to take money out in five years. You don't know, there's no certainty what that value may be in five years. You do get the edge when, and, again, you're making an assumption with this, but the bonds, when they mature, you have an idea what the value of that bond will be worth.
Emily Farrell: Yes.
Bryan Lewis: So you have more control over individual bonds than you do over a bond mutual fund. However, Vanguard, we recommend most investors are better off or better suited for the funds because of the diversification point that I made earlier.
Emily Farrell: Yes. So you're talking a little bit about kind of time, willingness, and ability as well—
Bryan Lewis: Absolutely.
Emily Farrell: —Which is a nice lead into a question I just saw pop up on our screen here. George asked us, "Can Vanguard investors get help from professional planners for allocation, and are these professionals CFPs?" So maybe you want to take it away. I think that sounds kind of familiar.
Bryan Lewis: Absolutely. So I'm a senior financial advisor in Vanguard's Personal Advisor Service, so the answer to the question is yes. We do have advisory services here that we can partner with our clients, so I partner with my clients on an ongoing basis. When you get into the advisory business, so I have a CFP or a Certified Financial Planner certificate, and the idea is we partner with our clients maybe who lack, to the point, Emily, you made earlier, about they lack the time to manage the portfolio. I have a number of clients that I manage who are in the investment field, but they just don't have the time to really manage the portfolio or they just lack the willingness or desire to really want to do this.
I also partner with clients that they can manage their own portfolios, but they're concerned about their spouses stepping into this, which is often overlooked. But we'll partner, and we've talked a lot about the portfolio side of things, so with the construction of the investments today, but there's other elements to it. So on an ongoing basis, we'll look to see if we have to rebalance the portfolio based on that plan. But we also talk and have discussions around estate planning, tax minimization strategies, legacy planning, so there's a lot of different things that we do when we partner with our clients on an ongoing basis for a small cost.
Emily Farrell: Yes, and just another reminder to our audience that information about Vanguard Personal Advisor Services, and a lot of you are asking about it, are in the green resource widget at the bottom of your screen.
So, believe it or not, with all of the ground that we just covered, we're just about out of time. I know I learned a lot. I think I said at the very beginning, bonds are something that kind of just, they kind of paralyze me, and I think maybe a lot of people have that kind of feeling, so hopefully this was a valuable discussion for everyone at home.
Before we wrap it up, I just wanted to see if either of you had any final thoughts for our audience at home.
Bryan Lewis: So final thought would be just to make sure you stick to your plan, remain disciplined, try to avoid the temptations to deviate from that plan, just to really try to remember the purpose of bonds. Right, you're not going to grow the portfolio significantly with a bond portfolio. It's really there for stability and supplemental income.
Emily Farrell: All right.
Kevin DiCiurcio: I'll just add a couple finishing thoughts. The one to me is the concern with the rising rates. The first thing I think of is something Gemma spoke to, is that we know that the Fed is on this tightening cycle, but it just doesn't mean if that short-term interest rate rises, it doesn't mean that your entire bond portfolio is going to decline in value. The yield curve moves in different ways.
So the benefits of being diversified is very important there. You know, duration not being the end all, be all of risk, you have to really consider what you're exposed to as well.
And the last thing is really the time horizon of the rising rates. You know, we know in the short term that you're going to potentially, in a rising-rate environment, you're going to see some capital losses. But if your time horizon is long enough, you can really see through that. As the higher income starts generating in your portfolio, at the end of your time horizon, those income gains are really largely going to offset any price declines you've had early on.
Emily Farrell: You've given me a ton to think about. Well, thank you both for all of your insights, and, unfortunately, we are out of time. To all of you at home, thank you so much for tuning in. In just a few weeks, we'll send you an email with a link to view highlights of our discussion today, along with transcripts for your convenience.
If I could have just a few more seconds, at the bottom of your screen is a quick survey. You can access that using the red widget at the bottom of your screen. We'd love to hear your feedback. We'd also love any suggestions on topics you'd like us to cover in the future. So from all of us here at Vanguard, thank you so much.
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