What we believe to be the issues with bonds…  The first would be potential return. The second would be the risk associated with return.

When returns are probably low and risk probably high – that combination can screw up a portfolio with a sizable allocation – which is nearly every portfolio we see in our day to day interactions with advisors.

If you own bonds, primary drivers of returns are the following:  Yield, or interest income (the coupon) and change in bond prices.  Think about today’s bond market:

• Yield/Income: You’re receiving historically low yields…I’m talking a 10 year treasury yielding 1.50%.  Factor in inflation of 2%, which is a questionable assumption, and you’re losing money on that.
• Positive Price Change: Bond prices seesaw with interest rates.  Rates down, bond prices up.  Rates up, bond prices down.   For example, say I issued a $100 bond to you with an interest payment of 3% for 5 years.  You give me $100 and I have to pay you $3 a year for 5 years and then give you that $100 back.  Well, if 6 months from now, the going 5 year rate is only 1.5%…the bond your holding is much more attractive and anybody looking for yield will pay you a premium for that higher coupon.    Again, can rates go lower…sure, but how much lower?  We’d argue the juice has been squeezed.

The bond math is ugly.

Like anything investing, if you want to make the math look better by positioning for higher return, you must take additional risk.  In bond land, you can take more credit risk or more duration risk.  What the heck are those?  Good question.

• Here’s Investopedia on credit risk: “Credit risk is the possibility of a loss resulting from a borrower’s failure to repay a loan or meet contractual obligations.”  In other words – you can find higher yields, but those higher yields come with strings attached.  Remember, in a world with treasury yields and S&P dividend yield below 2%, if you find outsized yield, make sure you understand the added risk.  As we say, stated yield is not always realized yield!
• Duration risk is a fancy way of saying sensitivity to interest rate changes.  In other words – more duration risk means greater movement in the price of bonds when interest rates change.  If they go down, it’s good to have duration risk, if they go up, it’s bad.

Here’s the bad news.  Investors are now being compensated at historically low levels for taking on these additional risks.  Said another way, we believe it ain’t worth it.

To close, bond returns of the past (specifically the recent past) have been great.  But, those returns have most likely robbed future returns.  Venk says it better than us when talking about recent bond returns:

“We fear that, rather than acknowledging their good fortune, investors are doubling down on it happening again. But the last time the market has seen two consecutive years in which the Agg has delivered over 5% total return was 2010/2011. The current economy is a very different level of risk than the one we saw just after the financial crisis. Rather than cheer the 2019 gain in fixed income and pat themselves on the back for a job well done, investors should realize that some of what should have been 2020’s performance was pulled back into 2019 in most duration-unconstrained strategies. This has reduced the already small cushion investors have if things don’t go as they expect… and maybe even if they do.”

Last thing we will say is that it is important to remember what historically has driven fixed income returns versus what drove them in 2019. Can rates continue to free fall downward while credit spreads tighten and re-create new historic lows? When building our return assumptions for 2020, we look at the current average yield of the Barclays Aggregate (which is 2.20%) as an indicator of the most probable total returns. From that perspective, it is easy to see that 2019 was an anomaly.

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When stock prices drop, don’t buy the lie that the market is broken. It’s not.  Your long term results are riding on how you behave during uncomfortable times.  If you want to get what the market gives (within your risk allocation), you need to be able to handle periods of bad returns – they are inevitable when dealing with risk assets. Account values dropping is a tough pill to swallow, but investors’ reactions impact the outcome more than any other input, and to keep those in check, keep these items top of mind:

#1 – Higher valuations tend to mean lower returns in the future.

The Shiller P/E chart below is a decent indicator of the relationship between the aggregate return of stocks and the associated opportunity costs. In other words, future returns tend to be lower when Shiller P/E readings are relatively high and vice versa.  In addition, higher valuations can lead to larger drawdowns. Both charts make sense intuitively and the data supports the reasoning. While lower prices hurt in the short run, they can work in your favor in the future.

#2 – The long-term direction of the stock market is up.

Zoom out on a historical chart of the stock market and it’s going from the bottom left to the top right.  We believe that long-term trend will continue. Warren Buffett seems to think that as well. Most would consider him to be a decent investor: Warren Buffett says he’s buying stocks “because I think they’ll be worth quite a bit more money, 10 years or 20 years from now”

Source: Bloomberg as of 02.01.2020

Notice in the chart above, the long term results come along side short term discomfort from time to time.  The emotions that come with falling prices lend themselves to in the moment behavior which can be detrimental to results and responsible for creating the behavior gap itself.  Don’t sacrifice long term objectives for short term comfort.

The two points above are great reminders, but may not be enough to lean on during turbulent times.  To help keep emotions in check, we construct portfolios to include strategies like trend following, value-dependent tail hedging, and defined risk.  Are they perfect? No.  But over the long-term, the evidence supports their ability to help deliver portfolio returns more attainable for investors. These exposures are designed for one reason – to minimize the behavior gap by building portfolios that are risk-managed but not return-starved.  They are not designed to avoid all volatility, but are designed to minimize the chances of severe drawdowns. If you are positioned to side step all volatility, you’ll also side step the upside as well.

No matter how you approach portfolio construction, it’s important to remember:  while short term volatility is uncomfortable and cannot be eliminated, the long term probabilities are skewed heavily in your favor.   Months like October can make that hard to remember.

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