Perceived Safety of Bonds

Perceived Safety of Bonds

Imagine standing in the middle of a field as a thunderstorm starts to roll through. About 50 yards away is a tall solitary tree. As someone who grew up in farming country, we grew up knowing that standing underneath the tree is the absolute worst thing we could do, even if it feels safer. The smart thing to do is to make yourself as small as possible by laying down on the ground, preferably farther away from the tree.

At times, our perception of safety can be dangerous. As interest rates have cratered, this is currently the world of fixed income. We have the historical perception of safety and income, but again, perceptions can be dangerous.

After I published The Fixed Income Conundrum (I encourage you to read it if you haven’t already), I wondered if I wasn’t emphatic enough about this.

In this case, this time just might be different with regard to fixed income. We are in uncharted waters as interest rates are at a historical floor with the fed announcing they aren’t going to raise rates until at least 2022. And yet, we may be sitting in the middle of the fixed income perfect storm.

We have had muted inflation for more than a decade during a period of time when the federal debt has more than tripled and we are at historically low interest rates. This is unquestionably good for borrowers – including the federal government – but not so good for retirees.

Let me be clear – I have no idea what is going to happen. Rates may end up pushing lower as there are countries that have had negative rates for a while now. But my feeling is that this isn’t setting up to be a pretty outcome for people following conventional wisdom of owning a high percentage of fixed income in retirement.

Just recently, Jeremy Seigel, Wharton professor and author of one of my favorite books, Stocks for the Long Run, has come out that a 75/25 portfolio is the new 60/40 due to this low-rate environment.

If inflation rears its ugly head, do you want to own low-interest bonds? Heck, even if inflation remains stable at 2%, low-interest bonds seem to be in trouble. And if interest rates rise, bond prices fall. That’s just the way it works. I just can’t see how this ends well given a long enough time horizon. I’ll let you decide whether that is five years or 30 years.

So, what are you to do? Aren’t equities overvalued? Possibly.

But are the overvalued in relation to bonds? I’m not so sure. At least for the current moment, the dividend yield of the S&P 500 is hovering around 2%. I realize that equities can be quite volatile in the short-run, but in my opinion, unless you are being forced to sell, a 2% yield – with potential for growing your underlying capital – looks better than fixed income at the moment. 

I will reiterate my feelings toward fixed income in terms of where it fits in the grand scheme of a retirement income plan. I most certainly advocate for owning some fixed income, but I think we should keep it simple. In my opinion, the primary (only?) point of a fixed income portfolio is to provide a buffer to the short-term uncertainties that come along with being an equity investor. That buffer is different for each person’s unique situation.

But the further down the spectrum you go seeking increased income from your fixed-income portfolio, the more you are correlating your fixed income to equities. In most cases, that correlation is the very thing you may be trying to avoid.

It is just starting to make less and less sense to me.  I will agree that equities look a little expensive at the moment, especially with all the uncertainties in the short run, but the further out you look, the worse and worse bonds look.

Stay the Course,
Ashby


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