August 10, 2020: Fixed Income In A Speculative Era

Aug 11, 2020 | Asset-Allocation, Bonds, Economy, Feature, Gold, Headline, Income, Investments, IRA, Markets, Mutual-Funds, Newsletter, Retirement

 

Re-balance Cycle Reminder All MyPlanIQ’s newsletters are archived here.

Regular AAC (Asset Allocation Composite), SAA and TAA portfolios are always rebalanced on the first trading day of a month. the next re-balance will be on Tuesday September 1, 2020.

Please note: As of March 1, 2020, we officially phased out our old rebalance calendar for both SAA and TAA. They are now always rebalanced on the first trading day of a month. 

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Fixed Income In A Speculative Era

It’s debatable on whether we are in a bubble. But probably most investors would agree that we are now in a speculative era, given extremely high stock valuation by many well known historical standards and extremely low bond yields. 

In this newsletter, we look at the role of fixed income in such an era. Specifically, we will look at our total return bond portfolios and see how they help to navigate through this environment. 

Stocks vs. bonds since 2001

Though it’s easier to have an impression that stocks (well, at least US stocks) have done a fantastic job for the past many many years, in reality they have lagged behind our bond portfolio Schwab Total Return Bond for the past 15 years (since 2015) or longer: 

Name YTD*
Return		 1Yr
AR		 3Yr
AR		 5Yr
AR		 10Yr
AR		 15Yr
AR		 Since 2001 AR
Schwab Total Return Bond 7.5% 10.4% 6.5% 6.4% 6.7% 7.9% 8.7%
VFINX (Vanguard (S&P 500) Index) 4.8% 18.4% 12.6% 12.1% 13.7% 9.1% 7%
VBINX (Vanguard Balance (60% stocks/40% bonds) 6.7% 14.8% 9.9% 9.0% 9.8% 7.6% 6.7%

AR: Annualized Return. All returns are total returns (dividend reinvested)

So even though you might have heard that stocks are ‘surging’ in many recent headlines, they actually did worse year to date (YTD) than the ‘boring’ bond portfolio. In a longer period, not only both S&P 500 (VFINX) and 60% stocks/40% bonds balanced index fund (VBINX) haven’t bettered the portfolio for the past 15 years or longer, they have suffered from much bigger interim losses (drawdowns). 

Furthermore, this portfolio actually did better than most standard allocation portfolios or funds (see some discussions of these famous funds) in most short and long periods:

Portfolio Performance Comparison (as of 8/7/2020)
Ticker/Portfolio Name YTD
Return**		 1Yr AR 3Yr AR 5Yr AR 10Yr AR 15Yr AR
Schwab Total Return Bond 7.5% 10.4% 6.5% 6.4% 6.7% 7.9%
MALOX (BlackRock Global Allocation Instl) 4.3% 12.4% 5.4% 5.4% 6.1% 6.5%
GBMFX (GMO Benchmark-Free Allocation III) -6.0% 0.9% 0.7% 2.2% 4.1% 5.3%
PASAX (PIMCO All Asset A) -2.0% 3.7% 2.4% 4.4% 3.9% 4.4%
DGSIX (DFA Global Allocation 60/40 I) 0.5% 8.3% 5.4% 6.1% 7.1% 5.9%

10 year chart: the bond portfolio is just a little bit shy of DGSIX for the past 10 years and better than others: 

So the boring one has won the race in the recent history. 

Opportunities and pitfalls of fixed income investments in the coming years

Before we go on, let’s hear a joke: 

The above tweet reveals many people’s feeling these days. Indeed, the central banks’ ultra loose monetary policies have driven bond yields to record lows. Furthermore, the Federal Reserve’s open market purchase of corporate bonds is providing a powerful backdrop to enable super easy corporate financing (low interest rates). For example, Bloomberg reported that Ball corp recently sold its junk rated bond at 2.875% interest rate, the lowest rate among all junk bonds in record. 

We see the following likely phases going forward: 

Phase 1: bond interest rates will remain low and maybe even lower for a while. In the event of a second wave of the current Covid19 pandemic or a deteriorating pandemic induced economy, the Federal Reserve will no doubt further drive down interest rates and do ‘whatever it take’ to prop up the markets. 

Phase 2: this might happen or might not (skipped over): the V-shaped economy recovery didn’t materialize and either it goes back down (in this case, stocks will be hit hard) or the recovery becomes a prolonged flat line (high unemployment rate and stagnated growth), in this case, interest rates can only stay low while stocks might do well or might suffer. 

Phase 3: A strong recovery eventually happens and stocks might do well for a while (along with bonds, though safe bonds will do less well but junk bonds or risky bonds will piggy back ride on stocks)  until we see high inflation. Stocks will then suffer, along with bonds. 

If we analyze all of these possible branches of likely scenarios in the above, we’ll find that bonds will have much higher chances (or in more scenarios) to do better than stocks by riding on the loose monetary policies. In fact, bonds will only do worse in a period when inflation is rising at some steady but slow paces and economy solidly grows at a slow but also stead pace (a Goldilocks situation). But even in this case, stocks still have a strong headwind of their extremely high valuation. Also, in this case, it’s easy to exit bonds, especially safe bonds (like Treasuries) and switch to higher risk bonds (junk bonds, for example) or just cash or even switch some to stocks. 

The above analysis tells us that even though the popular belief now is that stocks seems to be only alternative in the current ultra low rate TINA environment (TINA: There Is No Alternative (other than stocks)), it’s actually a lot safer and has a much higher degree of certainty to get reasonable returns by focusing on tactically investing in various bond segments. Specifically, we are seeing the following possible opportunities  total return bond funds (candidates in our total return bond portfolios) can offer:

  • Returns from corporate bonds: as stated, we are already seeing ‘surging’ of corporate bond prices (or lower bond interests) since this March. We believe they might still have further room to rise, especially in the current weak economy. This bodes well to funds like Loomis Sayles total return bond fund or PIMCO investment grade bond fund. 
  • Returns from foreign bonds: it’s said that many currency traders are betting the US dollar will weaken considerably going forward. If this indeed happens, a good total return bond manager like those managing PIMCO total return bond fund or PIMCO income will be able to utilize these opportunities and invest in foreign bonds whose prices will rise when US dollar falls. 

UDN: US dollar bearish ETF. It has risen from its low recently indicating a weakened US dollar. 

  • In dire economic situations, funds that invest in safer bonds such as agency backed securities (Double Line total return) will do well and probably much better relatively than stocks. 

To summarize, the scenarios in the above analysis are just likely situations and they are not bound to happen. However, through some rigorous analysis of these likelihoods,  we can see that if we are forced to speculate to derive higher returns (than the current rates and stocks can offer), it might be easier and safer to do so in fixed income using a tactical strategy like the one employed in our total return bond portfolios than investing in more volatile assets such as stocks. As a bonus, this might even turn out to have higher returns than stocks in the coming years. 

Of course, the above analysis also reveals that there are still several situations in which stocks can outperform. That’s why it’s important to always have some balanced and necessary exposure to the core assets like stocks and bonds. See  June 1, 2020: Minimum Equity Portfolios.

Market overview

We are seeing some encouraging positive developments recently: first, small cap stocks have started to rise more strongly than their larger cap counterparts. This indicates investors’ sentiment change as smaller businesses recover from the pandemic:

The relative strength of small cap stocks is still not strong enough. But if the uptrend momentum continues, small cap stocks would have a lot more room to go. 

In addition, the Covid19 pandemic seems to be stabilized and/or improved. Number of Infection cases has started to decline while death rate has improved dramatically from March. Of course, this by no means indicates we are now out of the woods: as more and more businesses reopen, chances of virus spread will increase dramatically. Furthermore, we are now close to a normal flu season and that will complicate the situation. Our subjective opinion on this is that it’s still full of many unknowns and this has to be taken into account in one’s expectation and investment decisions. 

Again, we call for patience and emphasize the following: 

  • For strategic allocation (buy and hold) investors, ignore the current market behavior. Remember, as what we have emphasized numerous times, when you choose and commit to a strategic portfolio, you essentially know and commit that your investment horizon (or the time you need to utilize this capital) is 20 years or longer. As we pointed out, if your investments are those diversified (index) funds such as an S&P 500 index fund (VFINX, for example), you know your money is in some solid ‘business’ that eventually (20 years later) will deliver some reasonable returns. As long as you are comfortable with this thesis, you should sit tight and forget about the current gyration.
  • For tactical investors, again, you have to ignore the current market noise. Furthermore, you should follow your strategy rigorously, especially in a time like this. Human emotion, both optimistic and pessimistic, and human desire, both greedy and fearful, are your worst enemies. This has been shown to be true time and time again.

In terms of investments, stocks are somewhat cheaper. Investors should not be swayed by the current market volatility and economic distress, instead, they should stand ready to take advantage of the opportunities. For most Americans, we offer the following Winston Churchill’s remark made in the darkest days of World War II: “The Americans will always do the right thing, but only after they have tried everything else.” As a country, the US (and the rest of the world) will get over this, as always, even after stumbles. The past development has been very supportive to our optimistic long term view so far. 

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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