Will Plan Sponsors Believe Their Lying Eyes or Will They Still Believe Bonds are “Safe”?
(The following is one of a special five part series meant to be shared by professionals and non-professionals alike. This particular series covers only one of the 7 Deadly Sins Every ERISA Fiduciary Must Avoid.)
What’s Really Wrong with Bonds
Ben Graham told us we should hold at least 25% of our portfolio in risk-free investments. His logic, of course, was that one never knows when the next depression will hit us. Of course, ol’ Ben lived through the darn thing and, maybe if he wasn’t a big-time finance professor at Columbia University, might have actually stashed all his cash in the mattress like his contemporary, my grandmother, did. But that’s just idle speculation. His concept of keeping a healthy portion of one’s portfolio in risk-free instruments made some sense. When he first developed the concept, risk-free instruments meant long-term government bonds. These bonds typically had double digit maturities, generally paid a relatively handsome interest and were (and still are – at least at the time of this writing) backed by the full faith and credit of the United States of America.
The Father of Modern Security Analysis believed it was always a good idea to have some ready cash just in case the market suddenly dropped and all these great blue-chip value stocks began flashing in your face. In this event, Graham says you should sell the bonds and buy the stocks. What’s more, since bond prices had very little volatility, you could rest assured you could sell the bonds pretty much for what you paid for them. (We’re left to wonder if dear old Ben would have pulled the trigger in November of 2008 or March of 2009, but, we can reasonably speculate he would have yanked that trigger at some point.)
My, how the world has changed. Once upon a time, investors held bonds upon the mantle of safety, security and low price volatility. Things began to change with the advent of inflation in the late 1960’s and early 1970’s. Double digit inflation a decade later thoroughly destroyed the familiar pattern of bond price volatility. Through the 1990’s and into the new century, despite the return of relatively low and stable inflation rates, the volatility of long-term government bond prices remained far above its pre-1966 levels. In fact, the volatility of bond prices today approaches the volatility of stock prices.
David L. Babson took a stab at answering this dilemma by identifying four differences between the modern bond environment and that of Ben Graham’s era (“Bonds are as Volatile as Stocks,” Investors Alliance Investors Journal, August 1996, page 7-8). First, Babson points to the growth in the overall size of the bond market. In less than twenty years (from 1978 to 1996), the bond market has grown more than eight times to $8 trillion. (Today, the size of the U.S. Bond market is $31.2 trillion according to Bank for International Settlements.) “With this many more borrowers, investors have to be enticed with greater yields,” declared Babson. He concluded, “small shifts in investor attitudes can magnify the swings of interest rates; hence, causing greater volatility in the price of bonds.”
In addition to the overall growth of the bond market, Babson felt the internationalization of financial markets, in general, had contributed to increased volatility of bond prices. In days of yore, the U.S Federal Reserve had great – if not exclusive – influence over the domestic bond market. Today, European banks and the Chinese government can have equal, sometimes even greater, influence.
With the growth of the investor class and the mounting array of financial products, we’ve seen increased speculation in the financial markets. “There has been a growth of derivative instruments,” said Babson, who also cited “a growth of Hedge Funds using these derivative instruments.” We’ve seen what happens when hedge funds guess wrong. In an eerie premonition, Babson felt such losing bets “can unduly influence the market.” He suggested the bond markets suffered in both 1994 and 1996 due to speculative failures.
Finally, since the 1960’s, we’ve witnessed a spectacular growth in all mutual funds, including bond funds. Babson referred to figures showing $3 billion in bond funds in 1970; $300 billion in bond funds in 1985 and, prior to the crash in the bond market, $800 billion in bond funds in 1994. (According to the Investment Company Institute, as of February 2010, bond funds currently hold $2.3 trillion in assets.) Babson felt rising interest rates attracted investors to bond funds. He saw the growth of bond funds as contributing to the overall volatility of bonds.
Babson ultimately concluded the financial markets had evolved to a point where price volatility of bonds is just about equal to the price volatility of stocks. He correctly pointed out “During the period of rapid inflation of the 1970’s, both bonds and stock fell 50%.” He goes on to add that, even during the low inflation period of the 1990’s both stocks and bonds suffered similar worst declines of 20% (albeit in different years).
Indeed, as the above graph shows, a review of the Ibbottson data through 2009 shows that, since 1970, while the price volatility – as measured by the standard deviation – of stocks has remained relatively in the same range, the price volatility of bonds has increased since the days of Graham-Dodd (and even Markowitz and Sharpe). The Ibbottson data reveals that today, the price volatility of bonds is nearly equal to the price volatility of stocks.
As if to prove the point, Dow Jones Asset Management ran a story based on a study performed by Neuberger and Berman, LLC (“Study Finds 50-50 Mix of T-Bills and Stocks Less Volatile,” Dow Jones Asset Management, May/June 1997 p.14). The study looked at the annualized total return (11.09%) and volatility (14.55%) of the S&P 500 from 1960 to 1966. It then compared these figure with various mixed portfolios. Each mixed portfolio would contain stocks and a fixed income alternative (separately, either 1-month Treasury Bills, 5-year Treasury Notes or 30-year Treasury Bonds). In every case, the asset mix including 5-year Treasury Notes produced a higher return with less volatility than a comparable asset mix including 30-year Treasury Bonds. In terms of how this compared with a pure stock portfolio, on average, the Treasury Note mix produced a return 1.33% higher with 7.67% less volatility compared to the Treasury Bond mix.
Of perhaps greater interest, a portfolio representing an 80% mix of stocks and 20% mix of 1-month Treasury Bills produced 92% of the returns of the S&P 500 with only 80% of the volatility. According to the Neuberger & Berman survey, the greatest differential between the return and volatility occurred in the portfolio containing 50% bonds and 50% 1-month Treasury Bills. In this mix, you cut the volatility in half but still retained four-fifths of the S&P 500 return (for a differential of 29%). The average differential for the Treasury Bill mix was 23.67%; for the Treasury Note mix it was 21.00%; and, for the Treasury Bond it was 10.67%. Clearly, these results suggest investors are not properly compensated for taking on the higher risk associated with bonds of longer maturities.
The idea long ago proposed by Benjamin Graham – always keep a portion of your portfolio in safe risk-free government bonds – remains as true today as it did when he first proposed it. What’s changed, though, is our definition of “risk-free” bonds. Long bonds have now become as volatile as stocks, requiring investors to flee to shorter and shorter maturities to guarantee some form of safety. Unfortunately, the language of Modern Portfolio Theory was written at a time when long bonds could have been considered risk free investments. Today, the fiduciary needs to update his thinking, anticipate the liabilities inherent in continuing to use old definition and, in no uncertain terms, avoid the 3rd Deadly Sin – Bond Insecurity. We’ll explore alternative methods to accomplish this in tomorrow’s final installment of this series.
Part I: How the Fiduciary can Explain the Practical Differences Between Stocks and Bonds
Part II: Defining the Perfect Bond: What Every Plan Sponsor Must Know About Bonds – Before They Crash!
Part III: 401k Plan Sponsors Beware: Are You Lighting a Match in the Powder Room Despite 1995 Study?
Part IV: Will Plan Sponsors Believe Their Lying Eyes or Will They Still Believe Bonds are “Safe”?
Part V: How the ERISA Fiduciary Can Avoid the 3rd Deadly Sin – Bond Insecurity