This past week, I was meeting with a client and the discussion turned to the low yield bond environment. The client has a pretty common question – isn’t there something that yields more?
The answer is yes, there are a lot of things that yield more than the investment-grade bond market. We could buy junk bonds, emerging markets bonds, or other questionable issuers. These kinds of bonds aren’t inherently bad, but because the issuers are financially weak or imperiled, they often fare poorly when the stock market falls, which means that they don’t offer much diversification during bad times.
Alternatively, we could buy regulated utilities, master limited partnerships (MLPs), or REITs, among other things. The problem here is that these are equity securities, which means that they can fall substantially anytime, regardless of what the overall market is doing.
Last year, for example, MLPs lost almost a third of their value while the S&P 500 gained 20 percent. MLPs aren’t inherently bad either, but for the ‘safe’ part of the portfolio, they hardly fit the bill.
A few people have asked why we don’t just buy the S&P 500 in place of bonds since the dividend yield is pretty close to the yield on the Bloomberg Barclays Aggregate index of investment-grade bonds.
Hopefully, the MLP example already gave you the right idea, but stocks have lost more than half of their value twice since we’ve been in business. Wow!
Yes, the market recovered both times, which is wonderful, but many of our clients are retired, and I want to impress upon everyone why the market coming back isn’t enough when you’re relying on your portfolio to meet your living needs.
I’m going to provide a silly hypothetical that illustrates the point.
Let’s say that you have $1 million invested and you’re pulling out $100,00 per year to maintain your lifestyle. Obviously, that’s not a good long-term plan, but I’m using these numbers to keep the math simple and get the point across.
Now let’s say that we get one of those 50 percent drawdowns and the $1 million portfolio is now worth $500,000. If you pull out the $100,000 to live on for the year, you’ve taken out 20 percent of the portfolio, and only have $400,000 available for the recovery.
If you aren’t pulling money out of the portfolio, you need the market to double to get back to your breakeven $1 million. But you need the market to go up 150 percent to get back to breakeven if you pulled $100,000 out, in our example.
And while markets have always historically recovered in the US (that’s not true in every country, which is why you diversify globally), they don’t always double in a single year. In fact, they’ve only doubled twice using the month-end data, and both periods were in 1933 after the market dropped more than 90 percent.
If you’re young and still saving, the drawdowns hurt, but not like they do when you’re retired and living on your portfolio.
And that’s where relatively safe bonds are still critical elements in a portfolio. I say relatively safe because even ‘safe’ bonds have risks and lose money periodically.
I find that most people understand this issue intuitively, even if they can’t articulate it exactly. And, I find that we tend to get more conservative as we age, so including more bonds gets easier, even in the low yield environment that we find ourselves in now.