By Rob Isbitts
The NFL has become a passing-oriented game. It wasn't always this way. Those of us who have watched that game the past 40 years or so remember when "three yards and a cloud of dust" was how games were won. Today, it's the West Coast Offense, crossing routes, drawing pass-interference penalties, and lighting up the scoreboard.
Bond investing used to be like old-time football. You invested for the interest rate the bond paid, and you held it to maturity. Later on, bond mutual funds and ETFs came along, and you could have a stabilizing force alongside your stock portfolio. Fast-forward to today, and the bond market of yesteryear is long gone.
Buying bonds and holding to maturity is still around, but with interest rates across the spectrum being either historically low or very risky (due to weak credit conditions), it is time for bond investors to face the realities of what that asset class has to offer: There are three possible outcomes, and two of them are bad.
One is negative returns and another is very low positive returns. It is one thing to start off with a low interest rate paid by your bond fund, but that is compounded by the extreme risk of rising rates on bond funds.
Unfortunately, at this major inflection point for bond investors, investor arrogance about bonds is peaking. Whether it's the equity investor who does not realize that equity returns have been flattening for a couple of years or the dividend investor who is in denial about the overvaluation of utilities and REITs after a great run higher, there is a feeling that things just keep on going without some payback for those who became complacent. The market has a way of punishing those who forget that investing is above all else cyclical, and that extrapolating recent results into the future is not only dangerous, it is often 180 degrees from what happens next.
You see, flows into bond funds have been unrelenting. And with a real risk of Federal Reserve tightening into next year, or a renewed credit crisis from the debt glut that exists in so many pockets of the global capital markets, I think those bond fund inflows are a combination of complacency and arrogance. I will try in one chart to set those people straight, and hopefully spark the search for bond alternatives for retirement income.
The chart is a result of a screen I did to find some of the bond ETFs that have bulked up on this investor craving for fixed income with rates near all-time lows. I eliminated ETFs with under $1 billion in assets and only considered ETFs that have been around for at least five years. There are four "high quality" funds and four that are of lower quality. The key column is "Max Drawdown (5Y)" which shows that most of these bond-market segments have declined at any point over the past five years.
As you can see, bonds can be volatile. Importantly, keep in mind that we are looking at a time during which interest rates have generally been falling, so market conditions for bond investors have been pretty strong. My concern for them is that they may have rushed the money into what was doing well, without realizing that this might be the last gasp in a bond bull market that has been in place since ... 1980. Don't expect a trend like that to reverse with a whimper.
There are alternative approaches to using bonds for income. I think that a well-constructed portfolio of stocks that pay above-average dividends, combined with a mechanism to defend against major market declines is worth a look from those who have been relying on bonds and assuming they were the only game in town.
In football, passing can produce a completed pass, an incomplete pass or an interception. Two out of three are unproductive. I think that bond investors should realize that the "passing game" in investing has changed, and they had better start thinking outside of that box.
What's your risk number? My firm has made available to Marketwatch.com readers the Riskalyze risk tolerance quiz. It takes about two minutes to complete, and by doing so you can estimate your "investment comfort zone" for short-term market volatility. You can go here to take the quiz.
This material was compiled by Sungarden® Investment Research. Sungarden Investment Research provides advisory services through Dynamic Wealth Advisors. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Past performance is not a guarantee or a reliable indicator of future results. Investing in the markets is subject to certain risks including market, interest rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. SungardenInvestment.com does not provide personal investment advice.