This Pie Chart is our Diversified Portfolio as of June 30, 2015

(Click directly on the Pie Chart to Enlarge it)

An Experiential Insight Into Bonds: Maturity (long-term vs short-term) horizon, government vs. corporate, highly rated vs lower rated (risk of getting your money back) and their place in the portfolio.

1. What are the riskiest bonds?
2. What are the safest bonds?
3. Why include them in a portfolio? 

A real life example of a risky bond: Dan just bought and sold a “risky” bond fund earlier this year.

Yeah, bonds are risky and can have excellent, double-digit returns. They also can be a tricky investment, if you think that bonds are universally safe by not decreasing in value. Well, I have news, they also have risks and can decrease up to 20% in value! Bonds are not as volatile as stocks. Bonds increase diversification which in turn reduces portfolio risk, and as a positive consequence, preserves your capital. That’s the primary reason why people near retirement and those in retirement should have a bond allocation approximately equal to their age. For example, a “Bogle rule” (age in bonds) offered by John Bogle (founder of Vanguard) is that 60 years-olds should allocate approximately 60% of their portfolio to a diversified selection of bonds. Bogle’s suggestion is debatable. It might be worth your while to check out this discussion on the Bogle Rule.

Bogle rule or not, according Your Money your entire portfolio should be diversified no matter what your age: http://www.yourmoney.com/investing/should-your-bond-allocation-match-your-age/ Our portfolio above shows full diversification: international and domestic stocks, international and domestic bonds, inflation protected bonds, various types of government bonds, and balanced funds which include stocks and bonds. The ready-made balanced funds offering both stocks and bonds such as Vanguard Wellington for younger investors and Vanguard Wellesley for older investors are good starter plans (I wanted Vanguard Wellington way back when I was a young teacher). Dan and I practice and live diversification, as shown in the pie chart above.

Bond returns have not kept pace with the inflation rate, the primary reason why holding 100% bond portfolio is a bad idea for most investors. Likewise, a 100% equity exposure is not proper diversification. Over time 100% equities have higher returns over bonds, however, there are periods of severe equity declines during crashes that most people cannot tolerate. Only investors in their early to mid 20s could get away with a 100% stock allocation, but not after 30 years old.

Most investors should have a bond allocation, since most of us will need them eventually as we age, we might as well learn about them when we are young. It’s that balance between stocks and bonds that ameliorates wide swings in our portfolio. Public and private pension plans, endowments and trusts have a combination of stocks, bonds and cash. Wealthy investors and retired people who can comfortably live on their pension plans and social security may decide to leave their investments to heirs, and thus don’t need their investments to fund their retirement.

“Splitting-Up” Your Portfolio into Stocks and Bonds is Not “Hard To Do,” it’s Essential For Capital Preservation, Diversification and Keeping Pace or Beating Inflation

This table Vanguard’s Model Portfolios was our salvation on a major decision. It helped Dan and I choose the proper stock-bond allocation split of 35% equity and 65% bond allocation shown in the pie chart. At our age, portfolio preservation is our number one priority. This allocation preserved our capital during the horrific 2008 stock market crash (Our portfolio declined only 11.8%). Dan and I need our investments for retirement income, so we use “Bogle’s rule” of age-in-bonds. 35% equity risk provide the appropriate amount of exposure to ensure our portfolio grew just enough to beat the inflation rate. Inflation is retirees’ primary obstacle to sustaining our retirement lifestyle. Retirees live on fixed income and don’t have “raises.”

Discover the Less Risky Bonds

Bond risks are associated with the increase in their maturity date and whether they are issued by the government or by corporations. The longer the maturity the higher the risk and higher their returns. While corporate and government bonds are the most sensitive to moves in the interest rate, long term corporate bonds are the riskiest (and can have higher returns) as corporations cannot print money, cannot raise taxes and have gone bankrupt.

Dan Bought A High Risk, Long-Term Corporate Bond

Here is a close to home example of what some investors are doing, chasing high-yield bond returns. Early this year Dan bought Vanguard Long Term Corporate Index Bond because it returned 25% in 2014 at low cost. I kid you not! This was Dan’s decision as he sold his position in a corporate bond fund offered by Loomis Sayles. He decided on Vanguard to lower his cost and to get out of Loomis Sayles as the lead manager, Dan Fuss, is in his 80s, so he may retire.

This was a break from our usual bond purchase as we decided years ago to only purchase short-term (1-5 year maturity), intermediate term (5-10 years) and mostly high-rated, AAA, AA or A. He got out of the Vanguard Corporate bond as it systematically lost value soon after he bought it (June 30, 2015 YTD return, .25%). He also knew that long term bonds are the most sensitive to rising interest rates and according to all of the reports for years now, those rates have got to rise sooner or later.

The maturity date is the time when the bond holder gets his or her money back with the promised interest rate. Longer maturity dates yield the higher return, but at higher risk. If bonds are used to keep volatility in check and reduce overall portfolio risk, it doesn’t make sense to increase bond risk. Portfolio risk should be taken on the stock side of the allocation, not the bond side. In today’s low interest rate environment, that’s precisely why even short-term bonds and cash have historically puny returns.

The riskiest bonds are:

1. Corporate more than government

2. Long-term more than Intermediate and short-term maturities

3. B-rated or lower more than AAA, AA, or A rated (rating guide).

The safest bonds are AAA rated, short-term government bonds.

Bond Books

It is always good to read a couple of books on bonds before investing. Here are two that I read and recommend:

1. Larry Swedroe’s “The Only Guide to a Winning Bond Strategy.”

2. Russell Wild”s “Bond Investing for Dummies, 2nd Edition.”

Video Series on Bonds

My favorite investment website is Bogleheads and their bond video presentations in their Wiki. Bogleheads are followers of John Bogle, founder of the Vanguard Group and the father of the indexing strategy.

Bottom line: Don’t chase high returns on any security. Construct a low-cost diversified stock and bond portfolio as shown in the pie chart above. Our stock/bond split (35%/65%) is appropriate for our ages, late 60s and early 70s. No matter what your age, you’ll rest easier with diversified holdings which fit when you need the money and your tolerance for risk.

 

Best of fortunes,

Steve and Dan