In part two of my series on bonds, I’m tackling three BIG questions:
- With cash yielding 5%, does it make sense to use money market funds (or t-bill) as a bond alternative?
- What should investors do if they own the wrong bonds and need to make changes?
- Does the current landscape shift how retirement investors should approach bonds going forward?
If you’re ready to dive deep into the research to understand this asset class better, you’ll love this episode.
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- Part 1: What the %@#! Is Happening to Bonds
- Term Premium: The Primary Drivers of Bond Market Returns
- Bonds vs Cash (2013-2023) With 4% Withdrawals
- The Basics of Sequence of Returns
- Higher Expected Returns for Bonds
- Why You Shouldn’t Abandon Bonds Right Now
- Dynamic Withdrawal Strategies:
Part 2: What the %@#! Is Happening to Bonds
Taylor Schulte: Welcome to the Stay Wealthy podcast! I’m your host Taylor Schulte and today I’m tackling part two of my “What the %@#! Is Happening to Bonds” series.
If you missed part one, I highly recommend starting there first because I’m building on that episode here today. Specifically, in part two, I’m answering three big questions:
1. With cash yielding 5%, does it make more sense to use money market funds or t-bills as a bond alternative?
2. What should investors do if they own the wrong bonds and need to make changes?
3. Does the current landscape shift how retirement investors should approach this asset class going forward?
For all the links and resources mentioned today, head over to youstaywealthy.com/204.
As noted in part one, if and how you invest in bonds depends on your needs, goals, and desired level of risk. While the current bond environment looks very different today than it did three years ago, the same principles of investing still apply.
In short, investment-grade bonds contain less risk than stocks. Therefore, an investor should expect lower returns from bonds over long periods of time. If an investor wants (or needs) higher long-term returns, then they should allocate more to stocks than to bonds.
To put some numbers to this, since 1926, U.S. stocks have had an average annual return of about 10%. Bonds, on the other hand, have had an average return of about 4.8% during the same time period. And cash, being the least risky asset class of all, has had an average return of about 3%.
There are, of course, time periods where the safe stuff outperforms the risky stuff, but on average, over long periods of time, you should expect higher returns when taking more risk.
With all of that being said, long-time listeners know that I don’t love comparing asset classes in isolation. Prudent, long-term investors typically own diversified portfolios made up of stocks, bonds, cash, real estate, etc. And measuring the performance and behavior of these different asset classes inside of a diversified portfolio often tells a different story than measuring them in isolation.
In a similar vein, we have to be careful measuring the outcome of a diversified portfolio under the assumption that the investor is simply buying and holding for long-term growth. Because, as you know (and as many of you are experiencing right now), the goal isn’t always to just buy and hold and grow our portfolio.
For those in retirement, the goal is to take regular withdrawals from their diversified portfolio over a 30-40-year time period to pay for living expenses, all while mitigating the chances of running out of money.
And the outcome of an analysis changes dramatically when comparing these two scenarios.
A very, oversimplified example, that isn’t really applicable to real life showed up on Twitter recently when a colleague shared that 3-month t-bills (aka cash) have outperformed investment-grade bonds for the last 10 years.
While that’s true, if an investor needed to withdraw 4% from their portfolio each year adjusted or inflation to fund retirement expenses, the investment grade bond portfolio outperformed 3-month t-bills. Again, not an example that’s applicable to real life, nobody would actually put 100% of their nest egg in one single low-risk asset class if they needed to fund retirement expenses for 30+ years.
But I wanted to share this example to emphasize that when taking withdrawals from our portfolio, the sequence of our returns – or timing of our returns – is a wildly important factor that sometimes gets overlooked.
In that last example comparing cash to bonds, the investor needed some of those healthier returns from bonds in the first few years to support a full 10 years of 4% withdrawals. Without them, inflation and regular withdrawals took a big chunk out of the cash investment in those first 4 years, making it harder to recover from in the final 6 years.
As a refresher, the sequence (or timing) of returns doesn’t matter when an investor is buying and holding their portfolio. It’s only when cash flows occur (i.e., contributions or withdrawals) do the results change based on the sequence of returns we get from our investments.
Now, while most people wouldn’t be deciding between a 100% cash or 100% bond portfolio, many investors I’m hearing from ARE wondering if they should replace bonds with cash in their diversified retirement portfolios.
In other words, instead of a 60% stock / 40% bond portfolio, many are wondering if a 60% stock / 40% cash portfolio makes more sense given that money markets are paying close to 5% and bonds have lost money these three years. Why take the extra risk in bonds? Why not just take the 5% from a riskless investment that doesn’t lose money?
It’s a great question, and one that my team and I have put A LOT of thought and attention into these last few years, and even more so in these last few months. But before I share my thoughts, let’s first quickly revisit one of the primary drivers of bond returns: the “term premium.”
In short, the “term premium” says that the longer you’re willing to wait to receive your initial principal back, the higher of a return you can expect. For example, under most circumstances, you should expect to receive a higher return – or higher interest rate – from a 5-year CD than a 1-year CD. The same can be said for bonds. A 5-year bond – or bond fund with a 5-year duration – will have a higher expected return than a 1-year bond or bond fund with a 1-year duration.
You should expect a higher return when buying a longer-term bond or bank CD because you’re taking more risk. That risk, of course, is that interest rates change during the time period of your investment.
For example, let’s say you buy a 5-year treasury bond today that’s paying 5%. But then interest rates go up, and that same bond 5-year bond is paying new purchasers 7%. Your 5-year bond paying 5% isn’t looking very attractive anymore. Of course, rates could also go down after purchasing your 5-year bond, and, in that case, you would be feeling pretty good about the 5% interest you’re receiving.
But we don’t have a crystal ball, and we don’t know what rates are going to do during the term of our bond. So, we are accepting some risk when agreeing to lock up our money for a period of time, and as we know, the more risk we take – whether it’s in bonds, real estate, stocks, or any other investable asset – the more risk we take, the higher of a return we should expect.
Now, some people don’t like taking risk. They don’t want to lock up their money for 3, 5, or 10 years…they don’t like the idea that a change in interest rates could negatively impact their investment.
So, instead of bonds, they gravitate toward something like a high-yield savings account or money market fund. These fixed-income instruments don’t have a term, they’re liquid every day and don’t fluctuate in value. They also don’t contain credit risk – your money is protected by FDIC or backed by the full faith and credit of the U.S. government.
It’s logical to most investors that if they invest in a riskless investment like a money market fund, they should expect lower returns over long periods of time. But today’s strange environment is proving to be challenging for even the smartest investors.
Investors see that they can earn 4-5% on their cash with no risk at all, and then compare that to buying an intermediate-term bond fund that also pays around 5%, but contains term, duration, and potentially credit risk – risks that have reared their ugly head in recent years. And these recent events have many investors questioning whether taking risk in bonds truly makes sense, and if they should replace their 60/40 stock/bond portfolio with a 60/40 stock/cash portfolio.
And I get it. It’s a great question. We’ve been through some strange, difficult years in the markets, and I think it’s prudent to examine – or even challenge – our asset allocation, and ensure that EVIDENCE continues to support the approach we’re taking.
As a starting point for answering this question, let’s first take a look at long-term returns for both a 60% stock / 40% bond portfolio and a 60% / 40% cash portfolio. For reference, I’m using the S&P 500 for the stock allocation, 5-year treasuries for the bond allocation, and one-month t-bills for the cash allocation.
So, from January 1st, 1926 to October 31st, 2023 – almost a 97-year time period – the 60% stock / 40% bond portfolio had an average annual return of 8.44%. The 60% stock/40% cash allocation, on the other hand, had an average annual return of 7.79%. And this is where things get interesting.
On the surface, after reviewing these results, an investor might quickly conclude that the return profile of these two portfolios is so similar that it’s not worth the extra 0.65% per year to take the risk in bonds. That you can just allocate that 40% to cash instead, and while you’ll miss out on 0.65% of returns per year, on average, you’ll never have to deal with the ups and downs of the bond market.
I agree, on the surface, that might be my conclusion too. If I’m going to take risk by investing in bonds, I’d want to be compensated fairly for taking that risk.
But there are, of course, a couple of things to take note of here before we jump to quick conclusions:
1. First, most people don’t buy and hold a portfolio for 97 years.
2. Second, if you did, you would be reminded that compounding is magical. Sure, 0.65% per year, on average, in extra returns doesn’t sound like much. However, when measuring the growth of wealth over that time period, the results tell a little different story. For example, a $10,000 investment in the 60/40 stock/bond portfolio grew to about $27M during that 97-year time period, while the stock/cash portfolio only grew to $15M. In other words, that extra 0.65%, on average, resulted in an extra $12 million.
3. Lastly, and perhaps most relevant to our listeners and the work I do for my clients, we don’t just buy, hold, and accumulate. In retirement, most people, to some extent, begin to take regular withdrawals from their investments to fund their retirement expenses and/or other goals. And, as noted earlier, the sequence of the returns we get from our investments when taking withdrawals from our portfolio matters A LOT.
Tyler Aubrey, lead planner and partner at my firm, has begun a deep research project on this very topic, comparing 60/40 stock/bond portfolios vs 60/40 stock/cash portfolios and modeling scenarios where an investor is taking regular withdrawals during different periods in history to fund retirement expenses.
As a disclosure, the project is still incomplete, and the research hasn’t been peer-reviewed or published. So, while the initial findings aren’t terribly surprising, the following is for informational and entertainment purposes only and should not be relied upon as advice.
So, in short, he’s using the same asset classes mentioned earlier when I compared the long-term returns of the two 60/40 portfolios over the last 97 years. The S&P 500 for stocks, 5-year treasuries for bonds, and one-month t-bills for cash. But as noted, he took it a step further, and assumed that a retirement saver withdraws 4% per year, adjusted for inflation for 30 years to fund retirement expenses.
As a market history nerd might expect, one of the only 30-year time periods where cash outperformed bonds was from 1950-1980. As a result, $1MM invested in 60/40 stock/cash portfolio ended that time period with about $400,000 more than $1MM invested in the 60/40 stock/bond portfolio.
This is that time period I referenced in part one of this series, where it was a death-by-a-thousand-cuts for the bond market. Long-term interest rates slowly increased from 2% to 15% over three decades.
And because rates slowly ticked up each year, the higher interest payments were never able to completely recover those short-term losses in bond prices. Interest rates increased a little, bond prices fell a little … the slightly higher interest now being paid by bonds started to make up for those small losses, but before bonds could get back to even, interest rates would increase again, causing the cycle to start over.
While cash proved to be the better “buy and hold” fixed-income asset class during this time period, the results get interesting when you run the same scenario, but instead assume that an investor is taking withdrawals.
For example, let’s say an investor retired in 1950 with a $1MM nest egg and needed to withdraw 4% per year adjusted for inflation for the next 30 years to fund retirement expenses. As we discussed earlier, because there is now a cash flow event occurring, the sequence of returns now comes into play.
And, as a result, the 60/40 stock/bond portfolio and 60/40 stock/cash portfolios end this 30-year time period in almost an identical spot. That $400,000 outperformance is nearly wiped away entirely when we model regular withdrawals being taken from the portfolio each year.
Knowing that this was the result of one of the worst, if that the worst, 30-year time periods for bonds, one can safely assume that in pretty much every other 30-year time period, the 60/40 stock/bond portfolio significantly outperforms the 60/40 stock/cash portfolio when taking regular withdrawals.
Let’s look at a couple of examples and preliminary findings that, again, as a reminder, still need some attention before officially publishing. Let’s start with 1926 since that’s where the data we have access to begins. From 1926 to 1956, a buy-and-hold 60/40 stock/bond portfolio outperformed the stock/cash portfolio by 0.69% on average each year.
Pretty similar results to the 97-year time period measured earlier, where an extra 0.69% per year might not seem very meaningful for that extra risk you’re taking by investing in bonds instead of cash.
But let’s now assume someone retires in 1926 with $1MM and, once again, needs to withdraw 4% per year adjusted for inflation. In this scenario, the 60/40 stock/bond portfolio ends the 30-year time period with just over $5MM, while the stock/cash portfolio ends the same time period with about $3.5MM.
A $1.5MM outperformance by the 60/40 stock/bond portfolio, which based on our preliminary results, is pretty much in line with the average outperformance across all 30-year time periods we’ve measured.
Now, both scenarios end this 30-year time period in healthy territory. A simple $1MM 60/40 stock/cash portfolio grows to $3.5MM even after accounting for 4% withdrawals adjusted for inflation each year. And this might lead an investor to conclude that they’re willing to give up the extra $1.5MM of outperformance in exchange for stability in their fixed income allocation.
However, we all know retirement is not a straight line. A perfect 4% withdrawal rate for 30 years sounds great on paper, but we all know life is going to throw us curveballs that take us off track. In addition to not knowing exactly what sort of 30-year time period we may find ourselves in, we might need to over withdraw in some years to pay for an unforeseen event.
Like most decisions we make in retirement planning, we typically want to optimize things that put us in the best possible position for success. We want to make decisions that stack the odds in our favor and create extra buffers in our plan to help us financially survive those events we can’t predict or plan for.
So, if a stock/bond portfolio that is distributing 4% per year (adjusted for inflation) has significantly better odds of ending a 30-year time period with a meaningfully higher balance than a stock/cash portfolio, a retirement saver may want to stick with their 40% bond allocation to help put themselves in the best possible position for success.
It contains a little more risk, but long-term investors – especially investors in retirement – have been rewarded properly for that risk. And in some cases, that risk was absolutely required in order to make it to the finish line unscathed.
As I already mentioned, throughout the 30-year time periods we’ve measured that model 4% withdrawals adjusted for inflation from a $1 million portfolio, on average, the stock/bond portfolio ends with a balance that’s $1.5 million greater than the stock/cash portfolio.
Beginning in 1940, it was only a $400,000 outperformance by the stock/bond portfolio. But beginning the 30-year analysis in 1970 or 1980, we saw outperformance spike to $2.3M and $3.8M, respectively.
Again, we still have more work to do, more numbers to crunch, and more feedback to digest before publishing the final results with more detailed conclusions. But, at the end of the day, it’s clear that we can and likely should continue to lean on the tried and true risk/reward formula to drive our investing decisions. If we want higher rates of return, if we want to put ourselves in the best possible position for long-term success, we have to take a little more risk.
Now, this doesn’t mean that retirement investors shouldn’t have an allocation to cash. Quite the contrary. If you’re in retirement taking regular withdrawals from your portfolio, a healthy allocation to cash is typically recommended. For those that are familiar with dynamic withdrawal strategies such as Guyton’s Guardrails, a cash allocation of up to 10% is often required.
So, for someone maximizing income from their portfolio by following a dynamic withdrawal strategy, their traditional 60/40 stock/bond portfolio might end up looking more like 60% stocks/30% bonds/10% cash.
In other words, some of the guesswork between holding bonds or cash is removed here. There’s actually evidence baked in academic research to support a strong cash allocation. It’s not an emotional decision or a market timing decision, it’s a prudent decision. If you want to learn more about dynamic withdrawal strategies, their rules, and why some require a 10% cash allocation, I’ll link to the retirement income series I published a couple of years ago.
So, we’ve covered a lot in this short two-part series. And what if, after listening, you’ve determined that you own the wrong bonds or have the wrong asset allocation? How should you go about taking action and making the appropriate changes?
In short, the textbook answer is to make the necessary changes immediately. And that’s because the future is unknown. And we don’t want to let unpredictable future events to prevent us from making changes that we need to make right now. If you’re taking the wrong prescription, your doctor likely wouldn’t suggest that you just continue taking it and wait and see how you feel in three months. The same can be said about our investments.
Having said that, there are situations in medicine where a doctor might suggest that you taper off from that “wrong prescription” before taking the new one so you don’t shock your body. And perhaps you feel the same way about your current investment allocation.
If you don’t want to shock your portfolio overnight…if it causes some anxiety and stress to make meaningful changes quickly…then devise a plan to systematically rebalance into the proper portfolio. Similar to dollar cost averaging, you could simply commit to making small changes every month for the next 6 months to get your investments into the right place.
This likely wouldn’t be the textbook approach, but as I always say, there’s the textbook answer and then there is your answer. And I’d rather see someone take action without spiking stress or anxiety than to see them take no action at all.
Ok, to wrap things up and bring us home here, what does the future of bond investing look like? Does the current interest rate environment shift how retirement investors should approach this asset class going forward?
In my opinion, the current bond market challenges don’t change anything. It’s certainly been a unique time period, but nothing has occurred that would completely uproot how a prudent investor would approach this asset class.
If anything, it has reinforced how important asset allocation decisions are. And it has reminded investors that the types of bonds you own is a wildly important decision and high quality bonds are not completely risk-free. Perhaps it has even opened up space for some learning opportunities, encouraging investors to learn more about bonds, why they belong in a portfolio, the risks they contain, and how to better understand the bonds they own.
The most notable change might be that the current environment provides higher expected future returns for bonds than three years ago. And that’s because the starting yield of a bond or bond fund is fairly accurate predictor of future returns. Since yields are higher today than they were three years ago, future expected returns are also higher. That’s welcomed news for investors who own bonds or need to begin adding more bonds to their portfolio.
At the end of the day, your financial goals should drive how you invest your money. Not what the Fed might do tomorrow or what someone's crystal ball says will happen to the economy next month or what’s happened to one single asset class like bonds over the last three years.
Your needs, and your goals should dictate exactly how you invest your money, how you balance stocks versus bonds, how much cash to hold, and if other asset classes like real estate belong in your portfolio. And if you’re not sure how all the puzzle pieces fit together and if you own the right types of bonds or have the right asset allocation, then consider leaning on a professional. You don’t have to go on this journey alone.
Once again, to grab the links and resources mentioned in today's episode, just head over to youstaywealthy.com/204.
Thank you, as always, for listening and I will see you back here next week.
Episode Disclaimer: 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.