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Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and today I'm wrapping up our four-part series on investing in bonds by talking about implementation. My goal today is simply to help you take action, to take what you've learned these last four weeks and make some meaningful improvements to your retirement portfolio.
So if you're finally able to wrap your head around the basics of bond market investing, and you're ready to go and take action, today's episode is for you. For all the links and resources mentioned, head over to youstaywealthy.com forward slash 88.
Okay, so to kick things off, I'm going to share some performance numbers from what many are now referring to as the COVID crash of 2020. And the crash began on February 19th of this year, and it bottomed out on March 23rd. So a little more than a one month drawdown.
During that timeframe, the S&P 500 ETF, the SPY, it fell 34%. And in case you're wondering, developed international stocks fell roughly the same amount. And while most of the attention was on the stock market, much of the bond market was also going for a bit of a wild ride during that same timeframe. For example, the investment grade corporate bond ETF LQD, it dropped 12.5%.
The iShares National Municipal Bond ETF, MUB, it was down 10%. And the iShares High Yield Corporate Bond ETF, as you might expect after learning more about the credit premium, this ETF was down just over 22% during the same timeframe.
I wanted to revisit these numbers to help kind of summarize and bring us home and share how I think about bond investing. The most common thing that I'm hearing about the bond market is something along the lines of, you know, with interest rates so low, real returns on bonds going forward could be negative. Why would I invest in an asset class with low or negative expected returns?
So first, I want to bring you back to the very first episode of this series where I mentioned that yes, the bond market is complex, but the great thing about bonds is that some basic math often allows you to pretty accurately predict the future of your bond investment. In fact, several years ago, Vanguard founder John Bogle concluded that the best predictor of future bond returns is today's current yield.
Since 1926, he found that the starting yield on the 10-year U.S. Treasury bond explained 92% of the return that an investor would have earned over the next decade.
Another study, which I'll link to in the show notes, came to a similar conclusion that the starting yield of the Barclays U.S. Aggregate Bond Index, this is an index made up of investment grade bonds, the starting yield of this index explains 90% of the next 10 year returns.
So to bring all of this into current day, what John Bogle and others are saying is that with the current 10-year treasury yielding 0.8% as of today, you might expect close to 0.8% annual returns from those bonds over the next decade. Adjust those expected returns for inflation and you could very well have negative real returns.
Really quick, just a reminder that these are expected future returns. And while studies have shown that the entry yield or starting yield is a good predictor, it's of course not 100% accurate. Changes in interest rates, as you've learned through this series, impact bond prices and returns.
And since we can't predict when rates will increase or decrease by how much and how quickly that change happens, John Bogle and others are not claiming to know the future with absolute certainty.
So with that, let's revisit the common theme and question that I'm hearing around bond investing, which is interest rates, AKA starting yields are low, which means real returns, AKA returns adjusted for inflation, real returns going forward could be negative. So again, why would I invest in an asset class with low or negative expected returns?
As you might imagine, this feeling is felt among many investors. And this feeling has pushed many people into the stock markets, pushed them out of their checking accounts and high yield savings accounts and out from underneath the mattress into the stock market and search for better future returns. It's also pushed investors into riskier bonds, these riskier bonds that have higher starting yields than U.S. treasuries.
While bonds have provided very generous returns to investors over the last 40 years, along with not expecting that trend to continue, I would encourage you to reshift how you might have been trained to think about bonds in the first place. Bonds, in my opinion, should be used as a stabilizer and a diversifier in a global portfolio, not a solution for trying to maximize returns.
And this brings us back to the series I did in September last month on investing in stocks, where we talked about the four dimensions of returns. The first of which says investing in stocks, the risky stuff, will provide higher returns over long periods of time than bonds, the safer stuff. Again, the more risk you take, the higher the return you should expect. In other words,
If you need or want a higher future rate of return, then you'll want to allocate more of your dollars to stocks. The bond market is not where you're going to boost returns, especially today. So the answer to why invest in bonds should be fairly straightforward at this point. We invest in bonds for diversification and stabilization. And the COVID crash of 2020 is a good recent example of this.
While investment grade bonds had negative double digit returns, like not good, but they were down much less than the US stock market. So, you know, we can conclude that they did their job. They added diversification and stabilization to the portfolio. They did their job. Or maybe I should say they did their job if you're still in the accumulation phase of life and not on the verge of retirement or living off of your retirement savings.
If you're on the verge of retirement, i.e. the most vulnerable time for your financial plan, double digit losses are not something that you really want to see. Thankfully, the market turned around pretty quickly this year, but hindsight's 20-20. We know that now and that isn't always the case.
Similarly, if you're regularly tapping into your portfolio to generate reliable, consistent income, and all of your investments are experiencing negative returns all at the same time, you might be challenged with where to take that next withdrawal from without causing long-term damage to your portfolio.
Again, the market came back quick this year and many retirees were probably prepared and at least had some cash reserves to weather the short storm. But if we have a repeat of 08, 09 or even something worse, and it takes 18 months or longer for your holdings to recover, and you're taking a lot of risk in your bonds and your stocks, you could be in some serious trouble.
So when thinking about investing in bonds and how to make decisions for your portfolio, it's important to first stop and identify what stage of life you're currently in. If you're in the accumulation stage and you have 10, 15, 20 plus years to retirement, you might choose to take some additional risk with your bond holdings to maximize what we call your risk adjusted return.
If you look under the hood of some target date mutual funds, you'll find that they take a similar approach here. The longer dated funds, for example, let's say a 2050 fund, will usually have more corporate bonds than shorter dated funds, like let's say a 2020 fund.
These shorter dated funds will typically have a higher allocation to safe U.S. Treasury bonds or AAA rated bonds to reduce risk as retirement savers approach the big day. To put that safety into perspective and share a real life example, during the COVID crash of 2020 this year from February 19th to March 23rd,
The iShares U.S. Treasury bond ETF, the ticker is GOVT, it had a positive return of 5.5%. As a reminder, SPY, that S&P 500 ETF, it was down 34% during that same time period where U.S. government bonds, at least the GOVT ETF, had a positive return of 5.5%.
Someone who's close to retirement or tapping into their portfolio for regular income can really benefit from that type of safety. Not only were U.S. Treasury bonds a diversifier and a stabilizer during that time period, but they were uncorrelated to most other asset classes. And historically, during catastrophic events like the COVID crash of this year or 08, 09 or others, it's
During catastrophic events like these, U.S. Treasury bonds have behaved this same way. When broad-based stocks have major losses, U.S. Treasury bonds tend to have positive returns. They're typically uncorrelated. But pushing those catastrophic events aside, as well as the stage of life that you're currently in, many academics, economists,
And professionals, including Larry Swedrow, have concluded that the additional risk of investing in corporate bonds just on its own just simply isn't worth it. It doesn't matter what stage of life you're in or whatnot, just taking the additional risk of investing in corporate bonds just simply isn't worth it. He highlights that from 1926 to 2017, this is a 91-year time period, long-term treasuries returned 5.5% per year,
And their riskier corporate bond counterparts returned 6.1% per year. So a premium of a little bit more than a half of a percent each year over a 91-year time period was given to corporate bond owners. And as Larry points out in his research, that's before considering implementation costs and considering an investor's total asset allocation. Remember, we have to be careful about
You know, looking at investments in isolation, it's very rare that somebody just owns corporate bonds and nothing else. You know, most people own some stocks or some real estate, maybe they own a business, people own other asset classes. So we do have to look at everything, you know, as a total asset allocation.
So the question becomes, and the question that Larry kind of set out to answer through his research is, is it worth the extra risk? Especially during catastrophic events like we saw this year in 08, 09, is it worth the extra risk to own riskier bonds? Is half of a percent premium enough of a reward?
I'll link to Larry's article in the show notes, but in short, he concludes that long-term treasury bonds simply mix better with the risk of stocks than corporate bonds. You also have to factor in taxes, trading costs, and liquidity risks, all of which favor treasury bonds and CDs, according to Larry's published research. To summarize, Larry says the following,
If you need or desire a higher rate of return from your portfolio, instead of adding credit risk, the evidence suggests you should consider taking that risk with equities. For example, increasing your exposure to small and value stocks and today to international developed and emerging markets with their lower valuations, not with corporate bonds. And
And if you decide to have an allocation of corporate bonds, you would be wise to consider some portion of that allocation as equity risk, aka stock market risk.
I realize all of this might be leaving you with more questions than answers. It is a complex topic. Given that I specialize in working with people over age 50 who are retired or close to it, we share Larry's approach to bond investing. And we favor U.S. Treasury bonds and Treasury inflation-protected securities to create what we call a war chest for our clients that serves as a safety net. That war chest represents, at the very least,
two to five years of their living expenses, and sometimes a lot more depending on their exact stage of life. In other words, we're managing the portfolio for risk instead of trying to squeak out the highest possible expected return. If a client needs or wants a higher rate of return, we'll simply reduce our bond allocation and add more to stocks, especially stocks that have more attractive valuations than some of these plain vanilla market indexes.
To bring us home here and help you take action, I'm gonna suggest doing two things. Number one, I want you to just sit down and just clearly identify and document, just write it down on a piece of paper
what stage of life you're in and how close you are to retirement. If you're within 10 years of retirement, let's define retirement as you're going to start leaning on your investments in your portfolio to create some income. So let's just, you know, you might continue working a little bit or volunteering or, you know, whatever, but let's just say you're, if you're within 10 years of retirement and leaning on your portfolio to
taking less risk with bonds and your portfolio in general is likely something that you're going to want to explore more, more so than if you're 10 plus years away from retirement. The caveat, of course, is to talk to your trusted advisors as this is not a personal recommendation. So step number one, I just want you to clearly identify and just be real with yourself. How close are you to retirement? If you're within 10 years, you should take a
consider taking less risk with your bonds. If you're 10 plus, 15 plus, 20 plus years out, maybe you're okay with taking more risk in your bond portfolio. Just document that. Action item number two, assuming that you own mutual funds or ETFs and you're not trying to navigate this maze of managing individual bonds, assuming that you own mutual funds or ETFs, take your bond ticker symbols and plug them into a free analysis tool like Morningstar.com.
The goal of doing this is to determine two things. Number one, the effective maturity of your bond holdings and number two, the credit quality of your bond portfolio. We also want to check for expense ratios. We want to keep those as low as possible, but you guys all know that by now. So the effective maturity of your bond holdings and your credit quality are what we're going to focus on here.
For example, if you go to Morningstar.com and you enter the ticker LQD, and then you click on portfolio in the sub menu, you'll find that only 4% of this fund is in AAA rated bonds, only 4%. The 90 plus percent is in single A and triple B bonds. So much riskier bonds. You'll also find here under this tab that the effective maturity of this fund is 13 years. So
So this exercise will help you identify how much credit risk and term risk you're currently taking with your bond holdings. So now you're asking, well, okay, what do I do with this information? Why do you suggest doing this? And here's the deal. I'm a firm believer that knowledge is power. For an example that everyone can relate to, let's just talk budgeting.
Instead of putting yourself on a budget, which everyone hates the thought of, I would suggest tracking your expenses first. Once you know where your money is going each month, you can then make decisions that align with your goals and values. Maybe you're okay spending $300 a month on a gym membership. Maybe that's really important to you.
That knowledge, that information, either for you or your financial planner is wildly important as you work towards creating a budget or even just a financial plan for you and your family. Just creating a budget or a plan out of thin air might lead you towards aimlessly canceling that gym membership, something that's really important to you and your quality of life.
And this concept can be applied to your investments as well, at least out of the gates here when we're working on, we're talking about portfolio construction. In other words, let's first understand what we currently own. Like, let's really understand what we currently are. Not just like I have a Vanguard fund or an American fund or a bond. Let's just say let's really understand what we currently own. How much risk are we taking with those positions and where are we taking that risk?
With that knowledge, you can then use the information that you've learned in this series and other podcasts and other sources that you might tap into. You can use that information with this knowledge to make meaningful changes to your portfolio that align with your goals. And heck,
You might find out through this exercise that you don't need to make any changes, but at least you know that you've checked that box and you can move on to the next item. Again, knowledge is power. And sometimes we forget that the easiest course of action is to just simply pause and understand our current situation before racing to make changes.
For the links and resources mentioned today, including all the research and performance numbers that I shared, head over to youstaywealthy.com forward slash 88. I hope you enjoyed this month's series on investing in bonds. I had a lot of fun going through it, and I look forward to seeing you back here next month. This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.