Is It Time To Ditch Bonds?

Wanderer
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I’ve been getting a lot of messages lately asking this question. Basically, people (including myself) are looking at their portfolios and seeing everything going up except bonds. They’re reading the news about interest rates being in the crapper, and they’re asking themselves “Why are we owning these things? All they’ve done lately is go down.”

Remember, the primary reason that bonds are used in an investment portfolio is that they act as stabilizers. They generally move in the opposite direction of the stock market, so when equities go up, bonds go down and when equities go down, bonds go up. This acts like a pendulum and keeps the entire system stable. So when people see bonds going down, they’re actually doing exactly what they’re supposed to. Not everything is supposed to go up at the same time.

However, one argument for changing our outlook on bonds exists, and that’s our outlook on interest rates.

Normally, guessing where direction interest rates are going to go is pointless, because not even central bankers know what they’re planning on doing. That decision is based on many factors such as economic outlook, inflation, and government policy, all of which change day by day.

However, right now interest rates are scraping the bottom of the barrel. Central banks around the world dropped interest rates off a cliff back in early 2020 and then started printing money in a frantic effort to keep the economy from imploding. For the most part, it worked (although many still-laid-off restaurant workers may disagree). We hit a short, sharp depression where economic activity ground to a halt as businesses were forcibly shut down because of the pandemic, but 12 long, painful months later, things are looking up again. Vaccines have been developed, shots are going into arms, cities are starting to re-open, and in all likelihood by sometime this summer or fall, some semblance of normal will have returned.

I’m not saying the return to normal will be smooth, though. All it takes is one nasty variant that the vaccines aren’t effective against and we’re all back to square one, but as of right now, it looks like we’re on the road to recovery.

And what that means is that the most likely direction of interest rates is up.

So if that’s true, how does that affect our bond strategy?

Investing in a rising interest rate environment is not a new situation. The last time we had to deal with this is back in 2017, which seems like forever ago. We could travel wherever we wanted and nobody had any idea where Wuhan was. It was a simpler, happier time.

A rising interest rate environment typically occurs as an economy recovers. Central banks gradually turn off the spigots of cheap money and allow interest rates to float back up. This way when the next recession happens, they have dry powder ready to deploy to stimulate the economy once again.

However, a rising interest rate can play havoc with your bond holdings because a rising interest rate makes bond prices go down. All of a sudden, the “safe” part of your portfolio starts to drop and look, well, not so safe anymore.

So here are three strategies that you can use to invest in a rising interest rate environment, as well as my totally subjective hot take on each.

As always, the opinions I express on each strategy are mine alone and should not be taken as financial advice. If you choose to implement any of them, do your research, make up your own mind, and own that decision.

Shorten Your Duration

This is the traditional advice for bond investors, and it has to do with how “long” your bonds are. Basically, the longer a bond is, the more affected its price is by interest rate changes. If you look at your ETF’s website, you can find a metric called the “duration,” which is a handy way of measuring the average length of your bond and its sensitivity to interest rate changes.

How it works is that if interest rates move one percent in either direction, the bond ETF will move in the opposite direction by this duration number. So for example, if we look at the Vanguard Total Bond Index page, we can see that it has a duration of 6.6 years, so if interest rates go up 1%, then the BND ETF value will go down 6.6%, and vice versa.

So when interest rates are dropping, you want to go long in your bond holdings because you’ll get more of an upwards boost in your ETF value. Conversely, when interest rates are rising (like now), you want to go short to lessen the negative impact. Vanguard offers short-duration bond index ETFs on both the Canadian (VSB) and the US side (BSV). You’ll give up a bit of income but you’ll more than make up for it in a lower capital loss once interest rates start to rise.

We’re actually planning on doing this to our Portfolio A bond holdings, but because central banks in both Canada and the US have pledged not to raise interest rates this year, we are planning on looking into this next year when we’re a bit closer to central bank interest rate hikes. I don’t want to give up my yield on these juuuust yet.

  • Pros
    • Less capital losses as interest rates rise
  • Cons
    • Lower interest rate

Up Your Credit Risk

Another way of getting yield in a low-yield world is upping your credit risk. This means pivoting away from super-safe assets like US treasuries and moving towards corporate bonds.

These bonds will still act as a stabilizing force in a portfolio, but will swing wilder than super-safe US treasuries because the risk level is higher. But in exchange, you will be getting a higher interest rate.

However, if you’re going to go down this route, be very careful to keep your corporate bond holdings at the BBB credit rating or above (known as Investment Grade). At this level, you’re mostly going to be getting bonds from financials like banks and industrials like energy companies. If you go below that searching for yield, your holdings will start to look more like this.

That’s a high yield bond ETF, and contains such champs as Caesar’s Entertainment (!), American Airlines (!!) and Carnival Cruises (!!!). Er…I wish these guys all the best, but I’m not touching a cruise ship company with a 10 foot pole anytime soon and neither should you.

Up here in Canada, we’re using an aggregate bond fund that also contains corporate bonds, and the yield spread between an aggregate bond ETF (VAB: 2.6%) vs. a corporate bond ETF (VCB: 2.8%) doesn’t make this trade-off worth it for us, but if I were American this would be a lot more appealing as the spread between the aggregate bond ETF (BND: 1.4%) vs a corporate bond ETF (VTC: 3%) is a lot juicier.

Vanguard also offers short, intermediate, and long-duration corporate bond ETFs as well, so you can really fine-tuning these first two knobs if you want.

  • Pros
    • Higher yield
  • Cons
    • Somewhat more volatile

Go Floating!

Here’s where we get funky. Rather than invest in things that pay a fixed interest rate, why not go with something that pays a floating interest rate instead? Specifically, I’m talking about Preferred Shares.

Preferred shares come in all flavours, and you can buy ones that have a non-fixed coupon rate. That way, as interest rates rise, so will the income you get from these preferred shares, which will also boost its price as well since they’ve become more valuable.

Here in Canada, preferred shares tend to be structured as rate-resets, which means every 5 years they reset their interest rate as a spread relative to the 5 year government bond rate, so the preferred market in Canada is naturally a floating-rate investment. In the US, preferred shares are issued as both fixed and floating, so you have to specifically find an ETF that invests in floating-rate Preferreds to get these. VRP is an example of one of these ETFs.

We actually owned preferred shares for the longest time as part of our Yield Shield strategy, and I’m happy to report that even with all the craziness that happened in 2020, preferred share dividends didn’t get cut, so this makes two recessions that these things survived. But at the beginning of 2020 as part of our ongoing portfolio simplification, we sold off our Preferred Share holdings and moved it into the traditional bond index.

Now with interest rates looking like it’ll come back up, Preferred Shares are looking super attractive compared to bonds. They pay a way higher dividend (4.5% – 5%), the dividend will increase with rising interest rates, and the ETF will go up in value as well.

So you’re probably wondering, a higher yield AND potential upside? What’s the catch?

The catch is that Preferred Shares don’t behave like bonds. While bonds tend to be anti-correlated with equities, preferred shares are positively correlated, so you’re losing the stabilizing effect that fixed income normally has on your portfolio.

For that reason, we’ve decided that we’re not going to put Preferred Shares back into Portfolio A since lower volatility is still important to us for our main retirement portfolio. However, our risk tolerance for Portfolio B, which we use to invest money we’ve earned from this blog and our book, is much higher since we don’t need that money to fund our day-to-day expenses. By swapping out our bonds in Portfolio B with Preferred Shares, we’re juicing our income, making Portfolio B more tax-efficient, and setting ourselves up to participate in the upside when interest rates start rising. However, this will make Portfolio B behave more like a 90% equities/10% fixed income portfolio rather than the 75%/25% split it was before. We are making that decision consciously, so if something bad happens with this vaccine rollout and stock markets swoon again, we’re not going to freak out that Portfolio B is dropping more than Portfolio A.

The ETF we’re using for this is the BMO Laddered Preferred Share Index ETF (ZPR), in case you were curious.

  • Pros
    • Higher Yield
    • Will rise in value with rising interest rates
  • Cons
    • Won’t act as a stabilizing force against equities

Conclusion

So there you have it. With interest rates in the crapper and an economic recovery hopefully on the horizon, these are the strategies you can use on the bond portion of your portfolio. Are you planning on doing anything to your investments? Let’s hear it in the comments below!


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40 thoughts on “Is It Time To Ditch Bonds?”

  1. Wow, amazing timing on this! I was wondering about this issue as well. Still want the 33% bonds in my portfolio vs. having that it all equity or cash, but was wondering on the returns on that thing. Think switching to shorter duration bonds makes a lot of sense. Will do some more research on the weekend and consider implementing 🙂

  2. I’ll just stay in 60% stocks and alternatives, 30% bonds(half government half Corp) and 10% cash. It always seems different this time, but I don’t think it is and I sure don’t want to invest the time and effort to try to time the interest rate impact on bonds. But your reasoning sounds dead on for people taking an active hand in their investment management. I wish I enjoyed doing that, but I absolutely don’t.

  3. We have just under 10% in bonds. I think that’s enough for now. If the stock market keeps shooting up, we may move some money into bonds. Otherwise, I’d rather invest in alternatives like REIT and real estate.

  4. I’m not advising it, but many investors bypass bonds altogether and instead go with public utility stocks/etf’s as a sort of bond proxy. It seems that many of the classic “widow and orphan” stocks/etf’s might also work as a substitute..
    …of course, the California public utility, PG&E, demonstrates the risk and downside to this strategy…

  5. Isn’t this the whole point of a balanced portfolio? As equity valuations go up you skip buying them and opt out for the discounted alternate. When the trend reverts you do the opposite.
    By reducing your “losses” via swap you also end up buying more overpriced assets like equities. Which should make you portfolio more volatile over time. (the more overpriced assets you end up owning the steeper will be an eventual drop next time). As with everything in this blog I would love to see some math behind this logic. As I am definitely not convinced here.

    1. What do you do with all the income yield in Portfolo B since you don’t live on that portfolio? Also, how is increasing income yield in Portfolio B more tax-efficient? Lastly, since preferred shares are positively correlated with equities, I would have thought you will just maintain equities/bond in Portfolo B to maintain the ‘purity’ especially when combined income and capital appreciation on preferred shares may not far exceed equities.

    2. After giving this another though over the long weekend I’d come to the realization that I’d misinterpreted the situation described in this article. The problem here is that @W & @FC are in a completely different situation then yours truly.
      Preferred shares might make sense in the drawdown phase, but never during the accumulation when your human capital act as a bond no matter the environment (as a former soviet citizen I look at the the capital markets in a slightly different perspective. Things which most people consider impossible I’d witnessed with my own eyes and that effect has left a permanent mark on the way I look at ‘safe’ assets).
      Anyway if you are reading this article and want to learn more. Please take a look at the following research paper by PWL Capital: https://www.pwlcapital.com/resources/the-role-of-preferred-shares-in-your-portfolio-the-risks-and-rewards-of-canadian-preferred-shares.
      It explains the pros and cons in this area and their recommendations if you decide to go this route (ZPR.TO being their choice, matching the fund mentioned in this article)
      Now about bonds. Aggregate bond ETF like VAB does not necessary behave in the way
      described in this article. It is more complex then just a simple YTM drop/increase per 1% change in interest rates. For this to happen you will need a so called a parallel shift in the yield curve. In other words, the yields on two-year, five-year, 10-year and 20-year bonds would all need to rise by 100 basis points for a fund like VAB to see a decline in the neighbourhood of 6.6%. There are certainly periods when rates all move by a similar degree, but this is rare. More often the yield curve steepens, flattens or even bends as interest rates change. What this means is duration doesn’t have much predictive power when it comes to diversified bond funds that hold a mix of maturities and if there’s one thing we should understand by now it’s that repositioning your portfolio based on forecasts is often disastrous. Making a tactical move like this—an implicit bet that long-term rates will rise and restore a more normal yield curve—is just a guess, and it can easily backfire.

    1. @odif Your own research paper mentions when correlations become more related to each other (e.g significant market uncertainty like Great depression, 2009 crash etc) and when they drift apart (inflation expectations, monetary policy changes)

      Given all the news about “expected” inflation in the US and Canada (due to helicopter money deployments aka COV19 stimulus) and the recent change in the monetary policy by FED (average inflation targeting over longer periods) can you bet today what is more likely to happen with those correlations in the next 10 years?

      By the way Bank of Canada is also considering and currently evaluating possible changes to the monetary policy at the end of the current 5 year term. (https://www.bankofcanada.ca/2021/03/results-consultations-inflation-monetary-policy/)

  6. This article feels like it should have been published a year ago which is when I made my portfolio changes.

    January 4, 2020: dumped ZPR (20% of portfolio) and bought VAB (20% proceeds of ZPR). Why? Pandemic in China. Some cases in Europe. Big. Red. Flag!

    March 31, 2020: dumped VAB (43% of portfolio) and bought VSB (10%), ZPR (25%) with other 8% to rebalance into equity ETFs. Why? Interest rates are practically zero. Hello! It can only go up from here.

    Since then, no changes other than deploying cash as it becomes available. When interest rates top out eventually, I’ll probably dump ZPR and VSB and buy back VAB.

    I made out like a gangsta! Without buying Bitcoin!

    Wanderer, you may be in need of an investment advisor. Call me.

  7. 40% bonds will always be in my portfolio. 20% of that in the short term and floating. But they do not inversely correlate with stocks anymore. They both go down together unfortunately. It sucks to invest lately.
    Where’s Firecracker by the way? It’s been a while we only se Wanderer post’s and I prefer hers better

  8. The advice about preffered share on canadian couch potatoe is enlightening. I think it is a complex product, with a lot of variation an details which require attention. It is also a relative small market maybe less appropriate to index investing.

  9. This type of investing style your suggesting will become a thing of the past. This investment has bigger returns year over year and that’s Bitcoin. 200% a year. People should look into this investment as part of your portfolio. This is not financial advice.

  10. I don’t own any bonds at all. Just equities, alternatives (that have cash flow), and a bit of cash. I feel a lot more comfortable this way. I prefer volatility to losing purchasing power due to inflation. But this is very much NOT for all investors.

  11. thanks for this .

    i dumped all my bond and Preferred etfs . in March 20 … and instantly exchanged them for equity ETF’s and stocks ..at super cheap prices ..

    great move .. my portfolio is up 90% in one year …. March 21

    i follow now what you describe as the yield curve ?

    i get enough dividends to live on .. so i don’t fret about market crashes

    and take advantage of them by buying bargains like last year . years of investing have helped me to not worry

  12. I thought a lot about my fixed income and with the low interest environment, preferred are a must. But preferred are strongly and positively correlated with the interest rate.

    So to neutralize that effect, what is strongly and inversly correlated with interest rate? Long term bond. And when you look at both products, you can visually see the inverse relationnship. By having half of each, I get a 1,5% greater yield than bonds and the two hedge each other when there is a change in interest rate in the market.

    And since I am in the accumulation phase, I can always buy more of the one that lose value.

    1. I’m at a loss reading this. You want to neutralize the benefits of rate reset / variable rate preferred shares by buying long term bonds?

      Why?

      Those preferreds are finally in their sweet spot. As interest rates rise, their yield will rise. At the same time, the capital component will grow too. That’s all beneficial to you.

      Who cares about getting a 1.50% greater yield on long term bonds. Do you realize the amount of capital erosion you will suffer holding long term bonds at this stage of the economic cycle? I can guarantee with 100% certainty it will be far more than that piddly extra 1.50% yield you’re grasping at.

      I’d highly recommend you get a 2nd or 3rd opinion from trained professionals before you exercise your strategy. The goal of managing a portfolio is to protect and grow your capital, not nuke it. You have no idea the damage you are about to do to yourself.

      1. Well the preferred will take value if interest rate rise. I own as fixed income :
        Long term bonds XLB on 1 year : -2,23%
        Preferred HPR on 1 year : 21,07%
        Net 1 year : 18,84% for fixed income.

        I do know that long term bond mean that a 1% change will shrink that value by 27%. Which is why the preferred are there.

        For your information, I did sell half of my long term bond position in march and april at their peak to buy growth assets. So now my fixed income position is 1/3 XLB and 2/3 HPR. I keep the remaining XLB to hedge against downside risk and having something in my portfolio that is inversely correlated to the stock market.

        I do know that I operate under the belief that we are in a liquidity trap and that BoC interest rate will not go over 2-3% and I am willing to revise those parameter if I see an evolution in the situation.

        I will take your opinion in consideration and suggest others do the same.

        1. Good on you to have sold half of that XLB in March/April. You sold high to buy low. I hope your strategy works out in holding the remaining XLB. It scares me but your risk tolerance seems higher than mine.

  13. (BND: 1.4%) vs a corporate bond ETF (VTC: 3%) is a lot juicier

    ——-

    These quoted yields are not dividend yields. Correct?
    What is the difference?

  14. I have ditched 60/40 and am more like 90/10 now. After being unfazed by the huge drops every day in March 2020, I decided I can psychologically live with the volatility.

    Preferreds also didn’t do what they were supposed to last time we were in a rising rate environment. The dividend and preferential tax treatment is nice, but for my situation (10+ year investment horizon, and registered accounts that aren’t even full yet), I no longer saw the point in holding them.

  15. A couple things:

    1)
    For fixed income / safe portion of a portfolio, I’d recommend people consider whether they have a pension plan and which kind. I know there is a lot of hate for people with a good pension plan, but the reality is that many workers in the backbone of society are public employees with solid pension plans (teachers, nurses, firefighters, police officers, utility companies, municipal employees, etc).

    I happen to be one of those lucky ones. I have decided that *IF* one has a *DB* pension plan with an organization that can not go broke (federal/provincial/municipal government, HOOP, OTPP etc), than this can be considered the “bonds” portion. Reasons are:
    – It is not correlated to the market
    – It provides fixed income
    – You already put significant amount of your income into it
    – It pretty much has a government guarantee. (look at all the money we spent keeping everyone afloat in a crisis. No way is any future government letting a major public-sector pension plan go broke)

    So, I did away with any bond allocation and I am going 100% equities, because I already put so much away into a DB (fixed income by definition) plan.

    2)
    @Wanderer: Why did you guys chose ZPR as your preferred shares ETF?
    (If you wrote about it already can you share the link to the article?)

    1. @NewB

      Perhaps bcoz ZPR has an attractive yield component than ohhh let’s say CPD and it’s maybe more tax efficient than ohhhh let’s say XPF? That’s my logic at least but I’m pretty certain @FC and @W has a strategy in place.

      I agree with you on the DB pension acting as your BOND component. If I had that piece as part of my portfolio, I would also elect 100% equity seeing the fixed income portion is likely to be indexed for inflation. The other option is to take the cumulative value of the DB amount and you control the investment strategy as you see fit. And the likelihood of me growing that amount further would be to my benefit or advantage unless of course, I really don’t know what I am doing and completely screw it up. Both of these options are a viable course of action. You just have to run the numbers in your projections and go with the best logical and objective option.

      For me personally, and as godfather JL would often state, my role in this lifetime is to be the “custodian” of these investments even though I am the sole owner of the funds. I am investing for 7 generations NOT one!

      ImmigrantOnFire

      1. How does ZPR, CPD, XPF compare on tax efficiency and yield?
        Last time I looked (it was indeed a few years ago) they looked pretty much the same…

        1. @NewB…

          I’m just saying at first glance, the last time I checked the yield on ZPR is 4.96% and I am thinking this is higher than both CPD or XPF. And when comparing ZPR to XPF in terms of their “eligible dividends” distributions, ZPR is more favourable. Again, that’s looking at this at a very high-level perspective but I am certain @FC and @W has a strategy better explaining their selection and decision process in holding ZPR in their portfolio seeing ZPR is more focused on rate resets due to its laddering strategy than your broad based indexes like CPD or XPF.

          Without researching further the overall configuration myself, I would not be able to differentiate which ETF is better suited for the situation at hand. I’m just saying if it was me, and I don’t know any better, I would select ZPR simply based on higher yield and tax-efficiency component. Nothing more!

          ImmigrantOnFire

  16. I have been retired for 14 years and feel comfortable with 80% stock/ 20% cash. I love to check the sale racks when stocks go on clearance like last March. Moving to 20% cash in this raising market makes me feel comfortable so I have a little buying power during panic selling.

    Bonds make me very nervous because first they aren’t even paying enough to cover inflation and second they are guaranteed to go down when interest rates go up, as they will one day.

    Preferred stock seems like the worst of both worlds to me; it lacks the collateral of a bond in bad times and lacks the dividend increases of a stock in good times.

  17. I did some reading a while ago about whether there is still a case for bonds. I found that bonds have lagged equities for I think it was the last 20-30 years. Also, with interest rates lower than ever, it appears that bonds will lag equities even more in the future.

    To me, if it’s fairly clear that bonds have lagged equities, why have them at all? Yes, they will reduce volatility. So for people who don’t have the stomach for fluctuations in their portfolio, OK. But for the rest of us, I think 100% equities is the way to go. I notice a couple other commenters above have said this, so I am adding my voice to theirs.

  18. I have what may be a dumb question about allocation. I’m in my wealth accumulation phase so I’m making huge buys all the time. Therefore, each time I buy, I’m targeting my 80/20 equities/bonds allocation. Since I’m always buying and rectifying the percentages, there is no annual reallocation event. Any thoughts on this?

    Wanderer I think this was a good, thought provoking article. I plan to look at VTC instead of BND for some of my buys to lower the credit rating some and get the possibility of a little higher yield.

  19. I recently learned about US Treasury I Series Savings bonds and they sound like a good way to hedge against rising interest rates and rising inflation while adding stability to a portfolio. It is only available to US citizens, there is a $10,000 a year limit and you can only buy from TreasuryDirect.gov, but aside form that it seems like a pretty good deal. Not sure if there is a Canadian equivalent.

  20. I have been holding about 100k in Vanguard Intermediate-Term Investment-Grade Fund Admiral Shares (VFIDX), which has been pretty flat/down a bit. Average duration 6.2 years. I have also considered moving this to a short or ultrashort bond fund to better meet its function. That said, holding this has given me the confidence to continue my strong allocation in equities.

    Regards,

    Max

  21. Well known author/advisor invests in PFFD a preferred stock index fund
    Vanguard HI YIELD-they garner the best of these bonds; worth a look

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