Think twice before dumping bonds

Low interest rates are a serious obstacle to funding retirement—you knew that already. The question is, what do we do about it?

For many investors and advisors, the answer is simple: stop investing in government and investment-grade corporate bonds, or at least dramatically reduce allocations to these asset classes. Popular alternates include high-yield bonds, emerging market bonds, or even dividend-paying stocks and real estate investment trusts (REITs) that generate income. There’s a role for these in a balanced portfolio, but a recent paper from The Vanguard Group suggests none is a proper substitute for high-quality bonds.

The researchers looked at data from 1988 to 2012 and zeroed in on the months when U.S. stocks experienced their lowest returns. They found high-yield bonds, emerging market bonds, dividend-paying stocks and REITs (as well as emerging market stocks, commodities and hedge funds) all tended to suffer losses during these periods. The only asset classes that went up when U.S. stocks tanked were Treasury bonds and high-quality corporate and international bonds.

The point here is not that emerging markets, real estate and other asset classes offer no diversification benefit. The problem is they don’t help when you need them most. “On average, many of the other asset classes have had low correlations with equities,” the researchers wrote, “but their long-term averages have masked a relatively high correlation with stocks during short periods of market distress.” Only government bonds (and, to a lesser extent, investment-grade corporates) softened the landing.

Not-so-great expectations

Will bonds provide similar protection in the future? The researchers addressed that question, too. Unfortunately, with yields so low, high-quality bonds cannot offer the same downside protection they once did. That means a traditional balanced portfolio of 60% equities and 40% bonds is more volatile today than it was when bonds were yielding 6% or 7% a decade ago.

Think for a moment about what that means. While many advisors are moving their clients away from fixed income because of low yields, the researchers remind us the opposite may be more prudent—at least for the risk-averse. “If investors have a risk tolerance that is defined by a maximum tolerable loss,” they write, “then their asset allocation should become more conservative and their return expectations must be lower.”

One of an advisor’s important roles is managing client expectations, and that includes helping investors understand that returns from fixed income are likely to be low for the foreseeable future. While it’s tempting to reduce a portfolio’s allocation to bonds, that strategy also introduces much more volatility and downside risk—more than most investors can comfortably manage. Telling an investor he needs to accept more volatility is like trying to talk someone out of their fear of heights.

Rather than trying to look for bond substitutes that are likely to disappoint, it may make more sense to help clients focus on what they can control: the amount they’re saving for retirement.