What is the Ideal Bond Asset Allocation?

In recent years, bond yields have gone from the Good, the Bad, and the Ugly. In most of Europe and Japan, negative yields have been introduced and bonds are now in an unforeseen territory. There is now over $11.7 TRILLION dollars worth of bonds with negative yields out there and, surprisingly, there are always buyers for them. These days, the ideal bond allocation seems less than ideal.

You would now need to pay someone to lend them your money. If you want to invest in these bonds, you need to pay interest each year!

It seems like investors are hoping to sell the debt elsewhere and make a profit when, and if,  prices go up when yields fall.

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The most plausible reason for these investors to consider a negative yielding bond would be if they expected price deflation, such that a given payout in the future is worth more than that amount today. It’s hard to rationalize such a view in most countries, – Jeff Cox

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Most of the negative-rate bonds are from the central banks of Japan, Germany, and France but many countries are now joining the trend.

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Source: Bloomberg

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Meanwhile, in the U.S., the Federal Reserve raised interest rates this past December from 0.50% to 0.75% and more increases are suggested to come. After the election of Trump, the benchmark 10-year Treasury yield shot up to an eight-month high and the benchmark 30-year yield hit 2.80% for the first time in 2016.

Everything seems to be aligned with higher interest rates in America but we live in a global economy with very low, or negative, rates overseas. Higher U.S. interest rates would likely attract overseas investors, which would pump U.S. bond prices up, and push yields back down.

It looks like gloomy days are ahead but the fall in interest rates has already hurt returns even for the large institutional investors. Here in Canada, our national social security program, the Canada Pension Plan (CPP), has taken a huge hit this quarter and some are starting to worry.

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A decline in North American fixed income markets and seasonal cash outflows cause net assets of the CPP Fund to dip below $300 billion. – Barbara Shecter

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The CPP Investment Board is now watching the bond market to try to guess where the market is heading now that Donald Trump has been elected. However, it is very difficult to know the direction the bond market will take (if not impossible to predict).

 

The received wisdom a few months ago was that we were in a lower for longer (period) and negative rates would continue for as far as you can see, but I think the market took a very different view on the elections in the U.S. and the new administration’s policies being very pro-growth. – Machin

 

On the bright side, for the first 9 months of 2016, CPP made $19.2 billion in profits, representing a total return of 6.9 percent after all costs. It seems like, once again, the big numbers are nothing else than media chatter.

I already mentioned how I highly discourage you to overreact to short-term movements. Numbers can be shown a thousand ways and articles can be written about any event. The important thing to remember is to always look ahead and keep a long-term approach to investing.

 

Quarterly changes in capital value of an investment fund “are noise…not signal – regardless of whether they are positive or negative. – Keith Ambachtsheer

 

The short-term variations might scare you but they are not the end of the world. Short-term variations are just noise and you should not look at your balances too often.

 

What is the ideal bond allocation?

If you are starting out and building your own asset allocation, how much should you allocate to fixed income? Well, that depends. Unfortunately, there is no easy answer to this one. The ideal bond allocation is different for everyone.

Your bond allocation should depend on your current stage in your journey. Someone who is retired or very close to retiring should hold enough fixed income to cover their expenses throughout a major correction in the stock market but someone in the accumulation phase might not need any bonds at all.

Bonds tend to hold their value in times of recession and, therefore, would be a better asset to support you when stocks are low. Having 2 or 3 years of living expenses in bonds might be wise once retired simply to cover when equities crash.

However, holding those bonds for too long prior to retirement might be unnecessary and lower your total returns. Holding a 100% equity portfolio right up until, or even throughout, retirement has historically increased your total returns and greatly extended the longevity of a portfolio. At the moment, as you can see in our Open Book series, we hold very little bonds and have stopped contributing to those funds.

 

The house always wins

While in our accumulation phase, we prioritize a healthy emergency fund, a high-equity portfolio, and then consider our mortgage as our fixed income investments for the time being.

1. Save at least 3-months of living expenses in our emergency fund,
2. Invest in a highly diversified, low-fee, equity portfolio,
3. Pay off our mortgage slightly quicker.

Paying off the mortgage on our primary residence quicker is similar to a bond allocation given the current interest rate environment where rates are at all-time lows and have very little room to go down. Since there is an inverse relationship between bond prices and interest rates, this represents a huge potential capital risk for longer duration bonds. When interest rates go up, bond prices go down.

It might seem inefficient to pay off our mortgage early when our interest rate is not even at 3% but bond yields are even lower! Posted fixed mortgage rates have always been above government bond yields so paying off your house will offer a higher return over the long-term.

 

Source: Bank of Canada

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The spread between posted 5-year fixed mortgage rates and 5-year government of Canada bond yields for this 10-year period, as shown above, averaged at 2.72%. This spread could go right in your pockets if you decide to pay off your mortgage.

In addition, retired or not, it is always comforting to have the safety net of owning your own home. Once you have paid off your mortgage, you will not miss the payments! This extra freedom and better potential returns are what pushes us to pay off our mortgage a little bit quicker instead of investing in bonds.

How about you, where are you finding your returns? Xyz.

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