What bonds should I include in my retirement portfolio?
- Noel Watson
- 7 days ago
- 6 min read
Updated: 3 days ago
Introduction
We've previously examined how bad the last five years have been for bond funds and the factors that should be considered when evaluating a bond fund. Today's post discusses the impact of these factors when building a portfolio containing bonds.
The role of bonds
Bonds are generally included in a portfolio for two reasons:
Reduce overall portfolio volatility.
Reduce portfolio drawdown (how much the portfolio's value falls during market stress).
As a reminder, the two main factors that can impact bond performance:
Interest rate risk (e.g. short, medium or long duration).
Credit risk (e.g. investment grade or junk).
There are many different opinions on what type of bonds should be included in portfolios, and below, we summarise some views of those we respect.
Interest rate risk
We see three schools of thought when it comes to interest rate risk:
Short duration, irrespective of the percentage of equity held in the portfolio.
The thinking here is that the bond element of the portfolio is not there to generate returns; this should be left to the equity content of the portfolio, but instead to minimise volatility and portfolio drawdown. Investment consultant Tim Hale, whose book we recently reviewed, follows this approach.
Medium duration, irrespective of the equity content of the portfolio.
Vanguard follows this strategy in its LifeStrategy multi-asset funds. They believe that (slightly) longer duration bonds offer more protection during equity market downturns.
Critics of this approach point to 2022 as an example of why it doesn't work, but given how muted equity falls were during this period (from a UK perspective), we struggle to understand their argument. You can see how well the "No Brainer", which also holds intermediate-term bonds, performed over various time periods versus other investment options.
Duration increases as the equity content increases.
Dimensional Fund Advisers is one of the investment firms we use. Their multi-asset strategy differs slightly from Vanguard as the bond duration increases as the equity component increases.
For example, the bonds in their 80% equity fund have an average duration of 4.41 vs 0.64 for the 40% equity fund.
Credit quality
Regarding credit quality, views are much more aligned, with most only considering investment-grade bonds.
Bond performance in isolation
As always, it's worth undertaking your own research before settling on an approach. For this blog, we will be using PortfolioVisualizer. There are a couple of things to be aware of:
The data we will analyse is for the U.S. only.
This data only goes back to the late 1970s, and most of the subsequent period was favourable for bonds. According to the UBS global returns yearbook, from 1982 to 2014, the world bond index returned a real (after adjusting for inflation) return of 7.4% per annum!
We will start by examining the following asset classes (more information on these assets is in the previous blog):
Intermediate-term treasury: Investment-grade bond with a duration of around 5.
Long-term treasury: Investment-grade bond with a duration of around 14.5.
High yield corporate bonds: Non-investment grade bond with a duration of around 3.
There are many takeaways here:
High-yield corporate bonds gave the greatest return (7.67% - see CAGR).
They also gave the best bang for your buck (0.47- Sharpe ratio).
Long-term treasuries are the most volatile (11.66% - Stdev) and have the largest maximum drawdown (45.29% from August 2020 to October 2023). Maximum drawdown is a key factor to consider, as diminishing portfolio values may lead retirees to capitulate and sell their investments at the worst possible time.
Judging by the above data, we might think that high-yield corporate bonds are the obvious choice. However, what happens if we add equities to the portfolio?
60/40 portfolio
We will now add U.S. equities to the portfolio (U.S. total market) and consider an investor holding 60% equities and 40% bonds.
We see some big differences when compared to the previous analysis:
The long-term treasury portfolio (portfolio 2) now gives the greatest returns (10.22%).
Intermediate-term treasuries (portfolio 1) give the best bang for your buck (0.58).
The high-yield bond portfolio (portfolio 3) is now the most volatile (11.47%) and has the largest maximum drawdown (39.71%).
It may be surprising that the high-yield bond portfolio now has the greatest maximum drawdown (which occurred from November 2007 to February 2009).
However, if we look at how long-term treasuries, high-yield corporate bonds and US Stock markets performed during this period, which coincided with the Global Financial Crisis, we can see the issue. High-yield corporate bonds start to behave like equities during times of market stress. Just when you really need them to work, they go missing!
Can high-yield bonds be saved?
What if we increase the bond content and reduce the equity content to try to reduce the maximum drawdown?
Alas, even with 90% high-yield bonds in the portfolio, the maximum drawdown is still larger than the other two portfolios. With only 10% equities in the portfolio, this leaves little room for growth. Given the differences in returns between high-yield bonds and U.S. equities over the whole period, you can see why it's not a viable solution.
What about short-term treasuries?
Now that we have discounted high-yield bonds for our 60/40 investor, should we consider short-term treasuries?
Vanguard's VFISX will represent short-term treasuries. According to Morningstar, this fund has an AAA credit rating and a duration of around 2.
From the above, we can see that while the 60/40 portfolio containing short-term treasuries has slightly lower volatility, it has a higher maximum drawdown (November 2007 to February 2009) and lower Sharpe ratio than the other two portfolios. If we examine this period for just the bond element of the portfolio, we can see that a longer duration was favourable during this period (which supports Vanguard's argument).
However, if we look at annual returns, we can see how painful holding longer-term treasuries was during 2022.
So far, we've examined just the 60/40 portfolio. What if we look at the investor holding a lower equity content?
Cautious investor
Cautious investors tend to be more unsettled by market turbulence, especially maximum drawdowns. For this analysis, we will reduce the portfolio equity content from 60% to 40%.
We can see that the intermediate-term portfolio offers the sweet spot, offering the best Sharpe ratio and lowest drawdown. The long-term treasury had almost twice the drawdown of the intermediate, therefore highlighting the risks of longer duration for the more cautious investor.
Adventurous investor
What if we increase the equity content to 80%?
The outcomes are reasonably close, with the long-term treasury having the slight edge regarding the lowest maximum drawdown and highest Sharpe Ratio.
The difference in 2022 drawdowns does not seem as stark as for the 60/40 portfolio.
Conclusion
It's probably best to summarise what historical data indicates what doesn't work rather than what does.
Junk bonds behave too much like equities during times of market stress
For the cautious investor, long-duration bonds have the potential to introduce unacceptable maximum drawdowns to the portfolio.
After that, decisions become much more nuanced and will be driven by your investing beliefs.
About us
The team at Pyrford Financial Planning are highly qualified Independent Financial Advisers based in Weybridge, Surrey. We specialise in retirement planning and provide financial advice on pensions, investments, and inheritance tax.
Our office telephone number is 01932 645150.
Our office address is No 5, The Heights, Weybridge KT13 0NY.
Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
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