Stocks have gotten very expensive, bonds very cheap. If you want to move money from equities to fixed income, use this guide.
By William Baldwin, Senior Contributor
Dramatic move this month from Vanguard Group: It’s saying that the classic portfolio of 60% stocks and 40% bonds, with which it has been so enamored for so long, might not be quite right. Consider, it says, going over to 40% stocks and 60% bonds.
Wow. Dumb old bonds are better than sizzling stocks? It’s not quite that simple. Equities still offer a return premium over fixed income. But the premium has shrunk. The reward is not as compellingly worth the risk.
To follow Vanguard’s advice you sell stocks or stock funds and buy bonds or bond funds. This guide will quickly steer you, via four questions, to the best bond buys. For most people the best thing is funds, not individual bonds. Some, but not all, of the recommended funds are from Vanguard.
The reason for Vanguard’s change of heart: The bull market has pushed down the earnings yield on the stock market. Bonds, meanwhile, have gone down in price, raising their yields.
A common comparison is between the earnings yield on the S&P 500 and the interest yield on conventional 10-year Treasuries. This comparison is naïve. Stocks provide something close to a real yield, a return that keeps up with inflation. So the comparison should be to the yield on Treasury inflation-protected securities, also known as TIPS.
S&P estimates that corporations in its 500-stock index earned $209 last year per index unit. That’s 3.5% of the index price. But this number has to get a haircut. Corporations have to plow back a seventh of their earnings in order to maintain their real earning power. (The arithmetic is explained here.) Make this adjustment, and you find that stocks offer a real return of 3%.
A 3% real return is less than half what stocks have offered on average over the past century. What about bonds? TIPS now pay a real yield just under 2.5% on the longest maturities. This reflects an extraordinary swing in investors’ favor. Four years ago these bonds were paying -0.5%.
What Vanguard is telling you: Stocks still offer a return premium over bonds but the premium is meager. Rethink where you fit on the risk/reward spectrum.
Savers looking for bonds have, at first glance, an intimidating task. Fidelity Investments puts 158,000 choices on its fixed-income page. You could, of course, have a fund do the picking for you, but then you have to choose the right fund. Including the different share classes, YCharts counts 7,700 of those things to sort through.
It’s not just the number of different bonds that is scary. It’s their volatility. Bonds are supposed to provide safety, but they crashed in 2022. We might get another spike in inflation, and that would destroy most bonds.
No professional advisor can make these uncertainties go away. Confront them head-on. Decide how much risk you can handle with a bond’s duration, its credit quality and its exposure to inflation.
Those three variables determine which bond fund is best. The fourth question is about whether you could do better skipping the fund and buying U.S. Treasury bonds directly.
This guide covers taxable bonds, the kind you’d have in a retirement account. Municipal bonds are another matter. Note: Munis make sense only for investors who are in high tax brackets and have a large percentage of their savings outside retirement accounts.
Our list of the 25 Best Buys among exchange-traded funds is limited to those with assets of at least $2 billion and annual expenses no higher than 0.06%, or $6 per $10,000 invested. In categories where many funds qualify, the list omits the ones that are smaller or more expensive.
What about mutual funds? Although these things are going out of style, they still offer some conveniences. The simple answer here is that mutual funds are an economic choice only if you have an account at Fidelity, Schwab or Vanguard. If you do business with one of these firms, you could search its platform for a house-brand mutual fund that resembles one of our Best Buys. Or you could skip the mutual option and buy an ETF from any sponsor at any of these firms or any brokerage.
This table is arranged in order of increasing interest-rate risk, but it is sortable on any column. To zero in on one or two funds, answer the first three questions.
Question #1: How Long?
As with bank CDs, so too with bonds: You decide how long you tie up your money. Go short, like two years, and you give yourself a chance to reinvest at better rates if they are higher in 2027. But you will regret this choice if rates come down.
Go long, like 20 years, and you may get a slightly better interest rate. Then pray that interest rates don’t go up, leaving you stuck for the remaining years with coupons that will then look meager.
Which way are rates headed now? You don’t know. Neither do financial advisors. If they did, they wouldn’t be advising you. They’d be making a billion dollars in the futures market.
Under the circumstances, a neutral bet is entirely defensible. Buy the whole bond market. That’s what you get in one of the funds listed in the table below as “diversified.” It’s a fund that matches what’s out there (excluding junk and foreign bonds): U.S. Treasuries, corporates, mortgage-backed securities. The Vanguard fund that does this has 11,300 bonds, and they have an average time to maturity of 8 years.
The maturity—the time until redemption of principal—is a fairly good measure of how sensitive a bond’s value will be to fluctuations in interest rates. But there’s an even better measure, called duration. That all-purpose Vanguard fund has a duration of 6 years. It will move up or down in value by 6% if rates move one percentage point. If rates go up one point, the fund’s value goes down 6%, more or less. If rates go down one point, the value goes up 6%.
Pick your poison. Settle on how long you want your money tied up. Select a fund that’s close to where you want to be. When it comes to risk in bonds, duration is the variable to think about first.
Question #2: How Much Credit Risk?
Security of principal ranges from the triple-A quality of the U.S. Treasury to the sketchiness of corporate borrowers on the cusp of default.
You get paid to take credit risk. Low-rated corporate bonds have better yields than high-rated corporate bonds, and high-rated corporate bonds have better yields than Treasuries. But losses to defaults take a bite out of the fat coupons on low-rated bonds.
During economic expansions the higher coupons on low-rated bonds more than make up for the damage caused by defaults. During recessions they do not.
Treasury bond funds sailed through the financial crisis of 2008-2009, while funds holding junk (politely known as “high yield”) were wrecked. Over the past 15 years, however, junk has done comparatively well. Morningstar informs us that the SPDR Bloomberg High Yield fund has averaged a total return (coupons plus price changes) of 5.1% a year, three points better than the return on the Vanguard all-purpose fund that owns only higher quality debt.
Pick where you want to be on the credit quality spectrum and select a fund that matches. Lacking access to a fortune teller who knows in advance what’s going to happen to the economy, you could adopt this compromise stance: 90% of your money in either Treasuries or a high-grade fund, 10% in a junk bond fund.
Question #3: How Safe From Inflation?
Treasury bonds come in two flavors, nominal and real. Nominal bonds pay back in dollars that are losing value. TIPS deliver a real return: Principal and coupons are adjusted for the cost of living.
A nominal Treasury maturing in 2045 yields 4.9%. The TIPS for that year pays 2.4% plus inflation. If inflation averages more than 2.5%, you’ll do better with the TIPS. If it averages less than 2.5% you’ll do better with the nominal bond.
What’s inflation going to do? Fortune-tellers again fail us. A compromise position is to go half and half. Put half your bond money in nominal bonds, half in TIPS.
Corporate bonds don’t offer cost-of-living adjustments, so you have to get all your inflation protection from TIPS. The nominal allotment could be in either Treasuries or corporates.
Question #4: Bonds Or Bond Funds?
Apart from overhead and transaction costs, there’s no difference in performance. A fund does exactly as well as the securities it owns.
That fact should not need to be stated. But somehow it eludes people. Last year a distinguished newspaper published this nonsense:
TIPS funds suffered losses of up to 30% in 2022 when interest rates shot up. (If you held individual TIPS, you wouldn’t have suffered a loss that year unless you had to sell.)
No, you can’t protect yourself from volatility by owning directly instead of through a fund. There are three other things, though, that distinguish funds from direct ownership: timing, diversification and costs.
Here, timing refers to the timing of principal and interest payments. You might want to time the principal repayment, that is, the lump sum at redemption. There is something to be said for buying an individual Treasury bond to cover a specific obligation at a specific date in the future.
The usual kind of fund won’t deliver precisely what you need because its portfolio is constantly updated, with maturing bonds replaced. It has no end date at which it delivers a known value of principal. There are exceptions to that rule: A handful of target-date funds own only bonds maturing in one specified year. They’re too expensive to make the table, but they might be right for someone who needs the lump sum.
Next, diversification among issuers. This is irrelevant if you are lending to the U.S. government. It’s a big deal in corporate bonds.
Vanguard has 2,200 different bonds in its intermediate-term corporate fund. You need at least 50 for a do-it-yourself portfolio. Also, since corporates are expensive to trade, it would be a good idea to have $1 million in each. So don’t buy individual corporate bonds unless you are investing at least $50 million.
Fifty million? This is dead serious. It’s a polite way of saying that if your broker wants to put you in an assortment of $20,000 corporate bond offerings, he’s not serving your interests.
After timing and diversification, there’s one more thing to think about in deciding whether individual bonds are right for you: costs of ownership. The good news here is that they are likely to be very low either way, assuming that you’re investing in the very liquid bonds of the biggest debtor of all, the U.S. Treasury.
Example: The SPDR Portfolio Long Term Treasury ETF charges an annual 0.03% fee. That’s $30 a year on a $100,000 investment. Then there are transaction costs. You’ll get nicked by middlemen when you get in or out of an exchange-traded fund. (There are no transaction costs on no-load mutual funds.) With the typical bid-ask spread of a penny a share for this ETF, you can expect to lose $40 or so round trip on a $100,000 trade.
Or you could be your own portfolio manager, dodging the annual fund fee. To make the same kind of bullish bet you get in that long-term ETF you could buy an individual Treasury bond due in 2045. There’s no fee (at most brokers) to hold that asset, saving you $30 a year there. But the round-trip transaction cost will be higher, probably between $50 and $300 on a $100,000 trade. Spread over 20 years, the money skimmed off by the bond market-maker is a bit less than what you’d pay the fund operator.
In sum: Buying individual bonds makes sense if (a) you’re buying Treasuries (b) you’re investing a six-figure sum and (c) you plan on holding for a long while.
If not? Sort that table.