On Asset Allocation: “Reducing Bonds? Proceed with Caution” says Vanguard

A great research piece by Vanguard I am reading this morning. With today’s bond returns at only 1-2%, should you reconsider your investments in bonds? Not so fast says Vanguard.

Low interest rates are hurting investors who require interest payments from bonds for retirement income. Because of this, investors are substituting bonds for dividend paying stocks and other alternative investments as a source of income. The Wall Street Journal reported a month ago about numerous bond funds adding stocks into their holdings to beef up their dividends:


The number of bond funds that own stocks has surged to its highest point in at least 18 years, another sign that typically conservative investors are taking bigger risks to boost returns.

In all, 352 mutual funds that are classified by Morningstar Inc. as bond funds held stocks as of their last reporting date, up from 312 at the end of 2012 and 283 in the first quarter of 2012, according to the investment-research firm.


This is a troubling trend. As stocks are reaching all time highs, investors are selling bonds (which have historically been a great hedge of risk for equities) to buy more stocks. This is adding more risk to investor’s portfolios than they may realize and may lead to long term problems far more significant than the short term problem of low income today.


Vanguard is out with a great piece on how replacing bonds with alternative investments exposes your portfolio to more risk.


It’s not just bonds’ higher yields that historically have contributed to their downside protection in declining equity markets but also the low correlations bonds have maintained with equities in these events. Today, broad exposure to the investment-grade bond market that includes an allocation to Treasuries, similar to that available through the Barclays U.S. Aggregate Bond Index, provides an investor with lower yields but is still likely to maintain low correlations with equities when stock markets sell off.

Bonds’ downside protection will probably remain, but the effect of that protection will be weaker, given today’s low
yields. Investors may be tempted to offset this weaker amplification from investment-grade bonds by substituting junk bonds, high-dividend stocks, emerging market bonds, or other high-yield assets.
The end result of such a decision, however, may be portfolios with higher total-return potential but greater downside risk when equities decline.
The diversification benefits of bonds in a stock/bond portfolio will likely persist. This feature, more than projected returns, justifies a strategic allocation to bonds. That said, lower projected returns from bonds and their diminished ability to generate high offsetting returns have important implications for downside risk and the asset allocation decision.
If investors have a risk tolerance that is defined by a maximum tolerable loss, then their asset allocation should become more conservative and their return expectations must be lower. Conversely, if investors place a premium on generating higher returns, as opposed to lowering downside risk, and as a result are reducing their bond exposure in favor of more

equities, they must be willing to tolerate more downside risk in their portfolios.

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