Bonds & low interest rates – Should you swap bonds for another asset class?
Disclaimer: This guide should be read in conjunction with the mini-guides on asset allocation (Stocks & Bonds and How much do you really need in bonds? so you may better understand the expected pros & cons of each asset class;
The purpose of these guides is to lay out the plan for building a successful investment portfolio for any investment profile. Our hope is that by the end of this guide, you would have learned how can swap bonds for other asset classes to optimize returns without taking on significant additional risk.
A short recap on bonds
Before we start, let’s recap the fundamentals we learned in the previous guides:
Stocks massively outperform bonds over the long term;
Stock prices can remain depressed for years;
Bonds don’t fall as hard as stocks in market downturns;
Bonds can act as great emergency funds;
If you’re living off your investments, bonds will provide for living expenses in bad times while stocks will provide for you in good times;
Excessive bond allocation in your older years is riskier than it sounds, as you risk running out of money if you live longer than expected.
In this vein we found that how much we need to hold in bonds isn’t as much a percentage-based allocation (e.g. 50% bonds 50% stocks) but has more to do about how many months / years / decades of security you need to have in bonds to feel financially secure.
Academics on bond allocation
Most books on books on asset allocation will point to historical data and conclude that, over the course of history, bond returns aren’t too far off from those of stocks. In fact, even adventurous stock market investors such as Benjamin Graham recommend some bond holdings. In his 1949 book The Intelligent Investor, Benjamin Graham advised even the most aggressive of investors to hold at least 25% of their portfolio in bonds. Graham concedes that while stocks do provide better returns over the long term, bonds will ensure you are never wiped out.
Of course, let us also not forget that Graham enjoyed an era where bonds averaged a 6% annual return. Today bonds yields less than 2%. So this recommendation should be taken with a grain of salt.
Estimating future bond returns
Bond returns are linked to interest rates. If interest rates increase, future interest payments should rise and vice-versa.
Unfortunately for bond investors, interest rates have progressively dropped over the last 30 years, as demonstrated in the chart below.
What’s worse is that interest rates haven’t reached a bottom yet. Just when we thought it couldn’t drop any further, we experienced negative interest rates for the first time.
Today, the 5 year US Treasury Inflation Protected Securities (TIPS), which has been recommended by countless academics and financial advisors as the best way to keep your money safe, is yielding a real (inflation-adjusted) return of -1.3%.
That’s right, today’s “safe” bonds guarantees you a loss.
While there is no way to tell what future bond returns might be, the indicators paint a grim picture:
Interest rates have continuously fell over the last 30 years;
Interest rates are kept artificially low by central banks through negative interest rates and quantitative easing in an effort to kick-start the economy;
Central banks have been telling us for years that interest rates will remain low for the foreseeable future;
Government debt is at an all-time high in the US, EU, and Japan. This makes it unlikely that any of these central banks will increase interest rates.
Here’s the bottom line: Bond returns are at an all-time low, and there is no indication that they will increase any time soon.
So what's an investor to do with low interest rates?
We’re now facing quite the dilemma. On one side bond returns are at an all-time low, but on the other side we need bonds to get us through the few years of financial turmoil we are bound to experience over our investment lifetime.
Some argue that we’re at an impasse, and that investors simply need to fill the gap by retiring later with a larger portfolio.
However others have found a way out, a way to optimize returns without significantly increasing risk. It goes something like this:
If we need bonds to survive market downturns, we may opt to swap some of our bonds for asset classes which perform better in these times. Let’s assess this move with two examples.
The Case for Defensive stocks
Markets behave strangely in times of stock market crash. Gold and silver, non-performing assets which barely keep up with inflation over time, suddenly jump in value while performing assets such as stocks crash like there’s no tomorrow.
But not all stocks behave the same way. While the stock market as a whole may drop as much as 35%, growth stocks (whose share price has already priced-in years of growth) tend to fall exceptionally hard. In contrast, stocks in defensive sectors such as food or consumer staples don’t fall as hard as the market average. Not only that, but they tend to recuperate their losses relatively quickly too.
This is what happened to Procter & Gamble (a company with a well diversified portfolio of products in consumer staples (shampoo, toothpaste, detergent, etc) in the pandemic-induced stock market crash of 2020. The stock dropped by 19% (as opposed to 33% for the S&P 500) and recuperated its losses in just two months. This happens for two reasons:
First a rising tide lifts all boats, and vice versa. In this case, as people panicked during the stock market crash, they took money out of mutual and index funds. This decreased the stock value of every stock on the market.
However, and this is where the second reason comes in: investors are not blind. Many investors recognized that this was a defensive stock, and quickly poured money in.
The same thing occurred in the 2007/08 crash. The S&P 500 had plummeted 54% from its peak while Procter & Gamble only lost 26%. Most importantly, the stock recuperated most of its value within a year, while the S&P 500 took almost 7 years to fully recover.
This is what happened to most defensive stocks, which were well-established and conservatively financed companies operating in defensive sector such as food, consumer staples, or utility.
The verdict on defensive stocks
While there is no free lunch, we can optimize our portfolio accordingly.
If we need bonds to provide for living expenses in tough times, and the bad times can last a decade, we don’t have to keep enough bonds to survive a whole decade.
Instead, we need enough in bonds to keep us afloat long enough for defensive stocks to return to their fair valuation. In essence, bonds enable us to “bridge” the time between a stock market crash and the time where we can start selling our defensive stocks.
So what's the right allocation of bonds & defensive stocks?
Of course, we can’t forecast how long a market downturn will last, nor how quickly defensive stocks will return to their fair valuations. However we can be fairly certain of two things:
Defensive stocks won’t fall as hard as the rest of the market;
Defensive stocks are likely to perform better than bonds in this low-interest rate environment;
In this case, it may make sense for investors to adjust their bond allocation accordingly.
For example, if you quantified financial independence as a monthly investment income of 3000$ per month. Under the 4% rule, you would need a portfolio totaling 900,000$ under a 60/40 stocks to bond allocation. This would allocate 360,000$ in bonds, which coincidentally is equal to 10 years’ worth of living expenses (valued at 3000$).
Under this scenario, if a stock market crash occurs tomorrow, you could survive by selling bonds for 10 years. In other words, you wouldn’t have to sell any stocks for 10 years, thus giving your stocks sufficient time to get back to their fair valuations.
As we have seen above, defensive stocks don’t fall as hard as the rest of the market during a stock market crash. Defensive stocks also return to their fair valuations faster. In this case, it may seem excessive to hold 10 years’ worth of expenses in bonds. Instead you could aim for 5 years.
This will give you 5 years of breathing room, where you can safely sell your bonds to cover your living expenses. At this point, if the stock market has still not fully recovered, you could then start selling your defensive stocks.
Of course, it is up to you to define how many years of “breathing room” you need to feel financially confident. If you’re adventurous, you could aim for just 3 years, but if you’d like to play it safe, you can aim for 7 or 8 years in bonds.
What are the risks of swapping some bonds for defensive stocks?
As we covered in previous min-guides, the real risk in investing isn’t market volatility, it’s running out of money.
Yes, bonds are less volatile than stocks, but they also perform worse over the long term.
It is pointless to try to play it safe by investing only in bonds. Most bonds don’t beat inflation today. So investing in (safe) bonds today is a guaranteed way to lose money in the short-term and run out of money in the long term.
In fact, academics have a term for this: Myopic Loss Aversion.
Myopic Loss Aversion is a condition where people are so scared of temporarily losing money in a stock market crash, that they forget the long term risk to avoiding stocks.
As such, people suffering from myopic loss aversion deliberately reduce their stock allocation. Some never invest in stocks altogether. They think they are “playing it safe” by investing excessively in bonds (or other “safer” investments) that yield lower returns. In fact, these people are quite happy to sacrifice a few percentages of performance in favor of greater portfolio stability. However these people are forgetting about compound interest. Let’s remind them.
In his book, The Four Pillars of Investing, William Bernstein found that compounding a 3% underperformance over 30 years results in final wealth 59% smaller than it should have been.
In other words, the fear of temporarily losing 20-40% in a stock market crash, leads to a 59% loss over the long term.
This brings me to my next point.
Defensive stocks perform better than bonds
Bonds probably won’t lose much value over the long term. This makes them great to stockpile for emergencies. But stockpiling 10 years of living expenses may be excessive.
Swapping half your bond allocation for defensive stocks will clearly increase your portfolio volatility. If you’re relying on your portfolio for living expenses, this does not seem ideal.
Yet, swapping bonds for defensive stocks may be preferable and here’s why.
For the examples below, we’ll assume we have 5 years’ of living expenses in bonds.
If a stock market crash occurs tomorrow, you would be foolish to sell any stocks. This is why you should always have bonds available. However, if you have 5 years’ worth of living expenses in bonds, and thus don’t need to sell any stocks in that time, the question becomes: Will defensive stocks fare better than bonds over the next 5 years?
Assuming that interest rates remain at current level, which is abysmally low, there’s a fair chance defensive stocks will perform better than bonds. But there’s still a chance they won’t.
Example #1 - The market crashes in 10 years
Suppose that a stock market only occurs 10 years from now.
Assuming a 5% yearly rate of return for defensive stocks and 2% for bonds, defensive stocks will outperform bonds by 33% over the 10 year period.
In fact, even if defensive stocks lose 25% of their value in the next stock market crash, you would still be better off with defensive stocks than with bonds (assuming a 10-year horizon).
Example #2 - The market crashes tomorrow
If a stock market crash occurs tomorrow you would be foolish to sell any stocks. In this case, you should sell bonds to cover living expenses. This is why you should always have bonds available.
However, if you kept 5 years’ worth of living expenses in bonds, you won’t need to sell any stock during that 5-year period. Therefore the question now becomes: Will defensive stocks fare better than bonds over the next 5 years?
Assuming 5% yearly return for defensive stocks and 2% for bonds, defensive stocks will beat bonds by about 15% over a full 5-year period. The question now is: Is 5 years enough time for defensive stocks to recuperate their losses from a stock market crash?
While there is no way of knowing how long will defensive stocks stay depressed following the next market crash, we do know that we have a 15% financial cushion. In other words, defensive stocks would need to lose more than 15% of their value over the next 5 years to make bonds the better choice in this particular example.
Example #3 - The market crashes in 2 years
If a stock market crash occurs in two years, and you have 5 years’ worth of bonds, then the time horizon is now 7 years. Will defensive stocks outperform bonds over the next 7 years? Most probably.
The verdict
As you may notice, the probability that defensive stocks will outperform bonds increases over time (as with stocks in general). Thus, how much you need in bonds is entirely up to your risk tolerance.
If you’re confident defensive stocks will outperform bonds over a 5 year period, then a five year bond allocation is sufficient.
If you’re right, you will enjoy a few extra percentage points in performance, even if the stock market crashes tomorrow. And if the stock market only crashes 10 years from now, then you’d be even better off (as you’ll enjoy 10 years of higher gains).
If you’re wrong however, you might be selling defensive stocks at a slight discount.
As you can see the risk to reward model persists, just make sure you’re not myopic about it.
The Case for REITS
Another way to boost portfolio returns is to swap bonds for REITS. REITS (Real Estate Investment Trusts) are available in most countries and provide long-term returns averaging 4%. REITS’ returns are often uncorrelated to those of the stock market which makes it a favorite for investors looking to add some stability to their investment portfolio.
You may be tempted to add real estate to your portfolio to increase diversification but there are three big issues with this asset class:
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REITS are highly illiquid;
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REITS are tax-disadvantageous;
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REITS returns are difficult to forecast.
First, REITS are highly illiquid. This takes away one of the main advantages of bonds, which is the ability to sell them relatively quickly while not losing any value. It can take weeks to find a buyer for REITS so make sure you always have some liquid assets (cash or bonds) to cover that period.
Second, REITS are tax-disadvantageous. By law, REITS have to distribute most of their profits to their shareholders in the forms of dividends. While this may seem advantageous, it isn’t. Your dividends are taxed upon receipt, meaning that your 4% expected gain will fall to 2.8% after tax. While this may not seem like much, it is. After factoring for inflation at around 2%, your net yearly gain is a mere 0.8%. This may not be worth switching out of bonds, especially given the illiquid nature of REITS.
Third, REITS returns are difficult to forecast as returns are affected both by rental income and real estate valuation. Contrary to popular belief, real estate prices are very volatile (we just don’t notice it as much as the market does not give us daily price changes as it does for stocks). To give an example, U.S REITS had annual returns of -17% in 1998 and +31% in 2000, that’s far from optimal passive income.
So when should you add REITS to your portfolio?
Contrary to the example of defensive stocks above, REITS shouldn’t lose value during a stock market crash. Instead you should be worried about a real estate crash, which happens far less often.
Given that there little correlation between stock & real estate prices, it could be wise to add some REITS to your portfolio. This way, in the event of a stock market crash, you won’t be forced to sell stocks to cover your expenses and could draw down on your holdings in bonds and stocks.
The verdict on REITS as an alternative to bonds
REITS can add a little diversification to your portfolio, and they can be used to boost long-term return through rebalancing too. However, unless you’re able to hold REITS in a tax-sheltered account, you won’t be able to escape taxes on dividends which will devastate your long term returns.
For these reasons, REITS should never completely replace bonds nor can they be considered suitable options to complement an emergency fund.
Conclusion
Bond returns are now at an all-time low, and there is no indication that interest rates will rise any time soon. Contrary to stocks, there are no arbitrage opportunities to buy bonds now. In fact, buying bonds today hoping that interest rates will rise tomorrow is a losing strategy. This will only erode the value of your existing bonds, not support them.
Still bonds retain some advantages. Bonds are highly liquid (they can be sold quickly) and retain most of their value in the event of a stock market crash. This makes bonds ideal to build an emergency fund and can help you survive a stock market crash.
Bonds offer insurance from a stock market crash. If you have enough in bonds to pay your living expenses in 5 years, then you’ve got a 5 year insurance plan. However we mustn’t fall prey to myopic loss aversion.
If you quit your job at 50 and expect to live until the age of 90, should you really hold 40 years’ worth of bonds? If not, how much is enough? 30 years? 15 years? 5 years?
We shouldn’t lose track of the fact that bond returns remain abysmally low. This threatens the conventional 60/40 stocks to bond allocation which has worked so well with the 4% rule.
There are ways to boost performance without any significant increase in risk. As we’ve above, the real risk isn’t volatility, it’s running out of money.
You can boost performance by reducing your bond allocation and replacing them with defensive stocks. While defensive stocks won’t perform as well as the market average, they will also not fall as hard in the event of a stock market crash.
If you hold 5 years’ worth of bonds, and enough in defensive stocks to pay for another 5 years of living expenses, your insurance plan is effectively 10 years long. Now, if a stock market crash only occurs in 10 years, then you could enjoy 10 years’ worth of gains on these defensive stocks and your insurance plan would have grown to 12 – 15 years.
Even if a stock market crash occurs tomorrow, and the value of defensive stocks have not recovered by the time you run out of bonds 5 years from now, there’s a fair chance that defensive stocks would not have fallen that hard. And even if you sell your defensive stocks at a 20% discount, you will still have enough to survive for 4 years before having to sell your long-term equity holding (which should preferably be in index funds).
To recycle the example above, a 900,000$ investment portfolio with a 60/40 stocks to bond allocation provides you with a 10 year insurance plan. However, switching to a 60/20/20 allocation (index fund / defensive stocks / bonds) provides you with a:
9 year insurance plan (5 from bonds, 4 from defensive stocks (assuming 20% discount)) if the stock market crash occurs tomorrow or;
13 year insurance plan (5 from bonds, and 8 from defensive stocks (assuming 5% yearly growth) if a stock market crash only occurs 10 years from now.
Of course these assumptions are purely speculative, but I invite you to play with the numbers yourself and tweak them to whichever doomsday scenario you want to be protected against.
If you’d like to read more on asset allocation, check out our other mini-guides on the subject at the buttons below!