Bonds in a portfolio and TIPS ladders
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Bonds in a portfolio and TIPS ladders
My internet access is short and occasional, so I thought I would put a few words together in a new thread.
If one were to take a 70/30 portfolio of stocks and bonds. Then imagine a 1970s scenario...
Stocks multiples fell and returns were unpleasant. In such a scenario, one would wish to keep hold of the stocks that have fallen in value. How do we accomplish this?
Bonds, that's how.
If one has a mix of large and small cap stocks, net of investment fees, the dividends may be only 1%. If living off a 4% w/r rate, this would mean selling 3% of something each year to achieve the 4% w/r.
Thus, one would have the option of not touching stocks, and selling 3% of your bond allocation each year. At the end of a decade, the bonds are all sold and you're only left with your stocks. Not pretty to be sure.
The silver lining though is that the stocks which are your highest returning broad asset class are given the longest time to recover their value. Bear markets can last 16+ years with dividends reinvested (to buy more shares are cheaper prices) but when living off dividends, stocks can take even longer than 16 years to rebound when adjusting for inflation. Few people discuss this, those that do always seem to assume one is in retirement but doesn't live off dividends. How insane is that?
Later, one could choose to rebalance the portfolio as stocks recover. Worst case, you sold bonds that didn't lose much capital value along the way and you held thru the worst of a market decline. Of course, heavy diversification globally and by cap-size, along with specific low-correlated equities like REITs, Oil & Gas, precious metals and so forth help here. But the name-of-the-game is to survive the bad return series, one does this only by holding onto as many stocks as humanly possible when the market tanks. Period.
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- TIPS Ladders -
This is a separate strategy to the more general perspective on running a portfolio that strategically includes high-quality, non-callable, short-dated bonds. There are some side benefits however.
If one held a 10-year TIPS bond ladder, one bond falling due each year, then with a 30% asset allocation one would automatically see 3% of your original inflation-adjusted starting portfolio value return into your brokerage account each year. One chooses whether to continue the ladder that year, or if the market has tanked, keep the funds.
Does this mean you are partly abandoning your TIPS ladder in a bad return series. Yes and no. The length of the TIPS ladder will shorten as you don't reinvest for 10-years hence, but you still have nine years falling due - one tenth of your original bond allocation each year - and get to make a new decision each year. The "side benefit" to this with a TIPS ladder is that one holds the bonds to maturity, which mitigates falling bond fund NAVs caused by (sometimes sharp) interest rate movements. You totally sidestep that problem. Short-term bonds lose predictability on returns and coupons, so do TIPS ladders but to a lesser degree. You can see your returns a little future out. On a 30% allocation you could eat thru 3% a year (1/10) for the next decade on not touch stocks at all.
In terms of the drawdown aspect, one could start out during accumulation with this plan but knowledgable that first and foremost your bond allocation is a form of insurance plan against your much higher returning stocks crapping out on you. They're the stuff that is safe in the port when the hurricane strikes. You tap that, leave the good stuff alone until you have to. If the return series on stocks is good, one draws down TIPS over many years. This is very slow and gradual. It increases the real returns of the bond portfolio but in a direct, purposeful manner.
In conclusion, a TIPS ladder is not separate to how one would ideally manage a portfolio. Equities being the higher returning (broad) asset class by far, one would naturally not wish to sell when their prices are low. Bonds are less important for returns and provide little real returns without intentionally drawing them down over time. Bonds provide the ability to achieve the higher returns that stocks can provide over long periods of time. If one is forced to keep selling via poor planning in all times, good & bad, then the higher returns of equities become purely theoretical during the distribution phase.
Petey
If one were to take a 70/30 portfolio of stocks and bonds. Then imagine a 1970s scenario...
Stocks multiples fell and returns were unpleasant. In such a scenario, one would wish to keep hold of the stocks that have fallen in value. How do we accomplish this?
Bonds, that's how.
If one has a mix of large and small cap stocks, net of investment fees, the dividends may be only 1%. If living off a 4% w/r rate, this would mean selling 3% of something each year to achieve the 4% w/r.
Thus, one would have the option of not touching stocks, and selling 3% of your bond allocation each year. At the end of a decade, the bonds are all sold and you're only left with your stocks. Not pretty to be sure.
The silver lining though is that the stocks which are your highest returning broad asset class are given the longest time to recover their value. Bear markets can last 16+ years with dividends reinvested (to buy more shares are cheaper prices) but when living off dividends, stocks can take even longer than 16 years to rebound when adjusting for inflation. Few people discuss this, those that do always seem to assume one is in retirement but doesn't live off dividends. How insane is that?
Later, one could choose to rebalance the portfolio as stocks recover. Worst case, you sold bonds that didn't lose much capital value along the way and you held thru the worst of a market decline. Of course, heavy diversification globally and by cap-size, along with specific low-correlated equities like REITs, Oil & Gas, precious metals and so forth help here. But the name-of-the-game is to survive the bad return series, one does this only by holding onto as many stocks as humanly possible when the market tanks. Period.
=-=
- TIPS Ladders -
This is a separate strategy to the more general perspective on running a portfolio that strategically includes high-quality, non-callable, short-dated bonds. There are some side benefits however.
If one held a 10-year TIPS bond ladder, one bond falling due each year, then with a 30% asset allocation one would automatically see 3% of your original inflation-adjusted starting portfolio value return into your brokerage account each year. One chooses whether to continue the ladder that year, or if the market has tanked, keep the funds.
Does this mean you are partly abandoning your TIPS ladder in a bad return series. Yes and no. The length of the TIPS ladder will shorten as you don't reinvest for 10-years hence, but you still have nine years falling due - one tenth of your original bond allocation each year - and get to make a new decision each year. The "side benefit" to this with a TIPS ladder is that one holds the bonds to maturity, which mitigates falling bond fund NAVs caused by (sometimes sharp) interest rate movements. You totally sidestep that problem. Short-term bonds lose predictability on returns and coupons, so do TIPS ladders but to a lesser degree. You can see your returns a little future out. On a 30% allocation you could eat thru 3% a year (1/10) for the next decade on not touch stocks at all.
In terms of the drawdown aspect, one could start out during accumulation with this plan but knowledgable that first and foremost your bond allocation is a form of insurance plan against your much higher returning stocks crapping out on you. They're the stuff that is safe in the port when the hurricane strikes. You tap that, leave the good stuff alone until you have to. If the return series on stocks is good, one draws down TIPS over many years. This is very slow and gradual. It increases the real returns of the bond portfolio but in a direct, purposeful manner.
In conclusion, a TIPS ladder is not separate to how one would ideally manage a portfolio. Equities being the higher returning (broad) asset class by far, one would naturally not wish to sell when their prices are low. Bonds are less important for returns and provide little real returns without intentionally drawing them down over time. Bonds provide the ability to achieve the higher returns that stocks can provide over long periods of time. If one is forced to keep selling via poor planning in all times, good & bad, then the higher returns of equities become purely theoretical during the distribution phase.
Petey
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ataloss wrote: so why would you hold tips and exclude em debt, junk bonds etc as in jwr's example
Hi ataloss,
If one holds bonds not for high returns but for insurance that one won't be forced to sell stocks for a decade when markets hit a prolonged bear market, then EM debt and junk would hold little appeal. You would want high-quality, short-dated, non-callable bonds which won't collapse with the stock market following an "event" or sharp spike in interest rates. As was seen in the Asian crisis, EM debt and to a lesser extent junk bonds fell sharply. Only corporate bonds, short and long-dated treasury did well. Particularly treasuries.
EM debt and junk bonds do provide some diversification, but really they provide return diversification from other equities rather than bonds. I do not exclude them at all, but consider them alongside other equity options available. Investors dump EM debt in a crisis and run to safe bonds. Anyone caught holding them will find values crashing just when they needed their (supposed) diversification power. They diversify just fine, but with other equity asset classes, not bonds. People like Ferri post on M* boards confusing this point and mix all bonds together in his bond asset allocation. Swedroe never made this mistake and pointed out correctly that when seeking safety in the sea port only high-quality, short-dated bonds will do. If one is going to accept the low returns that bonds provide, trying to jerryrig the returns by owning bonds that are unsuited to their purpose is not smart thinking. Whatever percentage held in a bond asset allocation should only be high quality stuff which can be truly relied upon. EM debt has been a wonderful antidote for poor recent large-cap returns but historically has not been good for insurance.
Petey
Hi Ataloss!
In fairness to JWR, his example was a "TIPS Ladder Example". It wouldn't make much sense to have em debt or junk bonds, since they are not TIPS.
(maybe they could be included in the other 60-80%???)
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ataloss wrote: so why would you hold tips and exclude em debt, junk bonds etc as in jwr's example
In fairness to JWR, his example was a "TIPS Ladder Example". It wouldn't make much sense to have em debt or junk bonds, since they are not TIPS.
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Beachbumz
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Life is Good.
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beachbumz wrote: Hi Ataloss!ataloss wrote: so why would you hold tips and exclude em debt, junk bonds etc as in jwr's example
In fairness to JWR, his example was a "TIPS Ladder Example". It wouldn't make much sense to have em debt or junk bonds, since they are not TIPS.(maybe they could be included in the other 60-80%???)
Beachbumz![]()
The things really is not to get too hung-up on TIPS ladder per se. That is a single approach to how to approach a portion of a bond portfolio. Nothing more, nothing less. It is up to the individual whether one chooses to use such an approach. Ultimately I do think that if one retired at 60, drawdown over 40 years so at age 80 half the TIPS bond allocation was gone, one would likely see they have perhaps 20 more years to live and reduce stocks down considerably at the stage. The thinking would be that one could not afford to them at age 80, wait out a bad 15 year bear market and the upside isn't worth chasing after, so likely an investor would add to their bond allocation whatever it was drawn down to by that point.
I hope that is clear.
Petey
In fairness to JWR, his example was a "TIPS Ladder Example". It wouldn't make much sense to have em debt or junk bonds, since they are not TIPS
Makes sense, also consistent with his use of non-real estate exclusively us based stocks as his equity portion of his example portfolios. That is, no one planning to retire on an investment portfolio would actually invest that way but it is used for an example of something.
Petey I agree that em debt returns have been high and volatile and this shouldn't be a retirees only type of fixed income allocation but it might provide good diversification for those of us who are exposed to a country with aging population, declining industrial base, insolvency, and extensive global political/military obligations.
Have fun.
Ataloss
Ataloss
Duh
I never looked at JWR's stuff as portfolio's - just good data sets to demonstrate research questions.
Nobody considers them actual portfolio's to be held by real people(do they???). JWR has pointed out the limitations of methods of calculation often enough.
Ataloss hit the nail on the head - hence my harping on male hormones(mainly for my own benefit).
I.e. Theorywise: a 60/40 balanced index Boglehead.
In actual practice:
75% Vanguard Lifestrategy mod
10% Vanguard REIT Index
15% DRIP stocks
And, and even there - the 15% was 17%(16.666%) the last time I marked to market - and 20 acres of timberland in Ms, I rarely count(may 'transform' into a vacation home and thus - off the table portfoliowise).
I never looked at JWR's stuff as portfolio's - just good data sets to demonstrate research questions.
Nobody considers them actual portfolio's to be held by real people(do they???). JWR has pointed out the limitations of methods of calculation often enough.
Ataloss hit the nail on the head - hence my harping on male hormones(mainly for my own benefit).
I.e. Theorywise: a 60/40 balanced index Boglehead.
In actual practice:
75% Vanguard Lifestrategy mod
10% Vanguard REIT Index
15% DRIP stocks
And, and even there - the 15% was 17%(16.666%) the last time I marked to market - and 20 acres of timberland in Ms, I rarely count(may 'transform' into a vacation home and thus - off the table portfoliowise).
peteyperson wrote:beachbumz wrote: Hi Ataloss!ataloss wrote: so why would you hold tips and exclude em debt, junk bonds etc as in jwr's example
In fairness to JWR, his example was a "TIPS Ladder Example". It wouldn't make much sense to have em debt or junk bonds, since they are not TIPS.(maybe they could be included in the other 60-80%???)
Beachbumz![]()
The things really is not to get too hung-up on TIPS ladder per se. That is a single approach to how to approach a portion of a bond portfolio. Nothing more, nothing less. It is up to the individual whether one chooses to use such an approach.
Petey
I agree, the point is that it WAS a 'TIPS ladder example'.
BB
Life is Good.
ataloss wrote:In fairness to JWR, his example was a "TIPS Ladder Example". It wouldn't make much sense to have em debt or junk bonds, since they are not TIPS
Makes sense, also consistent with his use of non-real estate exclusively us based stocks as his equity portion of his example portfolios. That is, no one planning to retire on an investment portfolio would actually invest that way but it is used for an example of something.
Hi Ataloss!
That sounds a little like Intercst too if I recall. He's pretty much anti-real estate and all S&P for equities too, right?
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unclemick wrote: Ah yes BB - you done good - whereas my RE has been only so-so or just ok..
Yep, right place at the right time, very unusual for me.
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There is a horse you rode in on element here.
Hmmmmm
Beachbumz
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Life is Good.
Real estate can be attractive for a retiree. It depends upon the individual and his local circumstances.
Some people love being landlords. Others hate the idea.
What kept me out of real estate after I had bought an apartment building was living through President Nixon's rent controls. Other than that, I did not like the hassle factor, but it was not too bad. Rent controls were the killer. Always watch out for hostile politicians.
Prices always make a difference, but prices in some areas are reasonable while others are ridiculous. The coasts tend to overdo things, especially the west coast. Prices are pushed way above affordability through political restrictions. Such restrictions can disappear overnight.
As for real estate finances, I recommend that you read FMO's posts from the earliest days of this FIRE board (around pages 2 or 3). Many stock market enthusiasts distort the facts regarding real estate. FMO gives you a good picture.
Investing in residential real estate is very attractive because revenues tend to be predictable, steady and often match inflation. OTOH, you have to be prepared for interuptions when tenants move out.
Have fun.
John Russell
Some people love being landlords. Others hate the idea.
What kept me out of real estate after I had bought an apartment building was living through President Nixon's rent controls. Other than that, I did not like the hassle factor, but it was not too bad. Rent controls were the killer. Always watch out for hostile politicians.
Prices always make a difference, but prices in some areas are reasonable while others are ridiculous. The coasts tend to overdo things, especially the west coast. Prices are pushed way above affordability through political restrictions. Such restrictions can disappear overnight.
As for real estate finances, I recommend that you read FMO's posts from the earliest days of this FIRE board (around pages 2 or 3). Many stock market enthusiasts distort the facts regarding real estate. FMO gives you a good picture.
Investing in residential real estate is very attractive because revenues tend to be predictable, steady and often match inflation. OTOH, you have to be prepared for interuptions when tenants move out.
Have fun.
John Russell
I think the use of bond ladder in bad market years could be useful.
But what one has a bad equity market year? When equity portfolio is flat? When it does not keep up with inflation? When down 20%? Due to the above I personally prefer the re-balancing method (which petey also mention) from a well diversified portfolio - rarely would there be NO winners - and even then one would take from the smallest loser.
A quick scan of the latest bear years shows that I would have taken from reits(+26%) and commodities(+32%) in 2000, from micro caps(+24%) and EM bonds(+23%) in 2001 and from gold (+33%) and commodities (+26%) in 2002. There are more winners in the 20% range in those bad years - that money would have been re-balanced to the losers (mainly large/mid caps).
With 10% in each asset class with only the above 2 winners per year one get more than the 4% w/r without selling any losers.
BB: Intercst actually have mostly single stocks - but you are right; mostly large caps and well diversified within that.
Cheers!
But what one has a bad equity market year? When equity portfolio is flat? When it does not keep up with inflation? When down 20%? Due to the above I personally prefer the re-balancing method (which petey also mention) from a well diversified portfolio - rarely would there be NO winners - and even then one would take from the smallest loser.
A quick scan of the latest bear years shows that I would have taken from reits(+26%) and commodities(+32%) in 2000, from micro caps(+24%) and EM bonds(+23%) in 2001 and from gold (+33%) and commodities (+26%) in 2002. There are more winners in the 20% range in those bad years - that money would have been re-balanced to the losers (mainly large/mid caps).
With 10% in each asset class with only the above 2 winners per year one get more than the 4% w/r without selling any losers.
BB: Intercst actually have mostly single stocks - but you are right; mostly large caps and well diversified within that.
Cheers!
Normal; to put on clothes bought for work, go to work in car bought to get to work needed to pay for the clothes, the car and the home left empty all day in order to afford to live in it...
With 10% in each asset class with only the above 2 winners per year one get more than the 4% w/r without selling any losers.
I guess I don't understand the point of pretending to be constrained to 2 asset classes including overvalued us stocks when there are so many obviously better ways to invest. (just me I guess)
Maybe the point was only that instead of readjusting assets yearly to meet a fixed ideal asset allocation (80:20 70:30 or whatever) one shoudl dynamically rebalance to avoid selling losers? Makes sense (and I'd do it) but unproved by the tips example.
If one has a mix of large and small cap stocks, net of investment fees, the dividends may be only 1%. If living off a 4% w/r rate, this would mean selling 3% of something each year to achieve the 4% w/r.
Thus, one would have the option of not touching stocks, and selling 3% of your bond allocation each year. At the end of a decade, the bonds are all sold and you're only left with your stocks. Not pretty to be sure.
extending the example of using an investment approach that no one would actually follow, I guess if someone wanted to do "research" that no one would follow, this could be tested vs historic data. I think that instead of consuming only bonds one might want to sell some stock in these scenarios especially if it was overvalued at the start of the period. ie if p/e is going to contract better to sell some in year one
Have fun.
Ataloss
Ataloss
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Petey, I agree that em debt returns have been high and volatile and this shouldn't be a retirees only type of fixed income allocation but it might provide good diversification for those of us who are exposed to a country with aging population, declining industrial base, insolvency, and extensive global political/military obligations
.
Hi,
I agree here, but it is difficult.
Lets say that one desired to have high-quality bonds to be relied up to cover any 5-year period where everything else did poorly. This sort of example is a good starting point with bonds because it covers situations like 2000-4, Asian financial crisis & the time subsequent to it, and so on.
Here you would be well advised to own 5-year or less duration, treasury bonds only from developed countries. EM debt does not hold-up in a crisis, people free for the safety of treasury debt. Adding corporate bonds that are investment-grade would still work, it can add a small extra return, but it does depend on what level of financial crisis you are covering. A market decline or "event" often seen corporate bonds still doing okay, as was the case with the Asian crisis. However, in something like 1929-1934, I am less certain whether corporate bonds on the whole held up as the US GDP shrunk by a third. Is reaching for the potential added return from corporates over treasury worth it or does it corrupt what you attempting to do with holding 5-years worth of bonds in the first place? Five years worth meaning spending rate, less dividends, equals bonds being sold off.
Beyond this scenario - one could call it the first line of defense - one is then under less pressure to hold such high quality bonds. I would see alternative assets like HY securities & absolute return as interesting assets in place of a higher allocation to bonds. The real returns have typically been higher than with standard treasuries and if it looks like a decade-long poor equity return sequence instead of 5-year, then one can tap those secondary assets in a timely manner rather than all in a panic. There is also some time for their value to rebound later while you spend down short-term treasuries. This is then moving beyond a financial crisis in which the equity market recovers in five years & you rebalance back to bonds then, and more of a equity-wide decline like the 1970s that would require another 5-years or more to sail through.
I think one needs to be clear as to the role of each individual asset allocation and where it fits in under various financial scenarios.
Petey
Are Tips overpriced?
This is a question I found at the Diehards board it has an interesting thread.
http://socialize.morningstar.com/NewSoc ... 1115541660
Kathyet
.I hear a lot lately that TIPS (and by implication, the TIPS funds) are overpriceId.
1- Do you agree with that assessment?
2- Should I continue to buy the TIPS fund in my retirement account? Thanks
http://socialize.morningstar.com/NewSoc ... 1115541660
Kathyet
Cathyet: That Vanguard Diehard post is interesting. I hope they keep going on the topic too.
Has anyone from the US who holds EM bonds considered placing them outside of their bond allocation? (I understand that non-US citizens may hold them for different reasons) As Petey said above, EM bonds can not be relied upon as a safe haven during wild market swings which is the main reason most people hold bonds. I have also seen examples where they are not good long term investments. However, in the short term, some hold EM bonds more likely for other reasons, such as hedging against the falling dollar. So wouldn't placing EM bond holdings somewhere other than among ones safe haven, fixed income/bond category and instead in a distinct category of their own or within the equity portion of a portfolio be more appropriate?
Has anyone from the US who holds EM bonds considered placing them outside of their bond allocation? (I understand that non-US citizens may hold them for different reasons) As Petey said above, EM bonds can not be relied upon as a safe haven during wild market swings which is the main reason most people hold bonds. I have also seen examples where they are not good long term investments. However, in the short term, some hold EM bonds more likely for other reasons, such as hedging against the falling dollar. So wouldn't placing EM bond holdings somewhere other than among ones safe haven, fixed income/bond category and instead in a distinct category of their own or within the equity portion of a portfolio be more appropriate?
I am the one with the sandwich board on which is written in red letters, "I haven't the foggiest notion what I am talking about."