Bond Portfolios Have Been Corrupted

I happened across this tweet last night:

If you are unfamiliar with Bill Gross, he founded the mutual fund powerhouse PIMCO and for a long time ran the largest bond fund in the world, PIMCO Total Return. He’s something of a legend in the bond world. For a while, though not anymore, if Bill Gross said it, you could take it to the bank.

The tweet, as you can tell, expresses shock that Mr. Gross’s new bond fund, the Janus Henderson Global Unconstrained Bond Fund, holds 15% of its assets in one stock, Aetna, Inc.

I highlight this not so we can spend time digging into the investment philosophy of Mr. Gross, but to speak to a larger point. That is, that bond portfolios have been corrupted over the last 10 or so years.

Bonds, in their purest form and function, are designed to do two things: primarily, to provide stability to a diversified portfolio, and secondarily, to provide income. And when I say “secondarily,” I mean a distant second. Bonds primary purpose are to support your portfolio when stocks are running red.

The challenge for bond managers and investment advisors is that the low interest rate environment mandated by the Federal Reserve coming out of the financial crisis created a disincentive to hold traditional bonds. If you were selling performance, it was hard to get excited about investment grade corporate bonds or government treasuries paying 2-3%. So what did most managers and advisors do? They took on risk.

You can call these flavors of bond investing “unconstrained,” “strategic,” “flexible” “high yield,” “high income” or “floating rate.” But, no matter what they are called, the idea is to juice returns over and above traditional bonds. Some do it by reducing the quality of the bonds they own (lower quality equals higher yield), others by buying more risky stocks, as Mr. Gross seems to have done. No matter how it’s done, it corrupts the part of your portfolio that is supposed to provide ballast, thereby increasing the risk of your portfolio.

(Let me be clear: risky bonds have existed for a long time. I’m not trying to imply they came about solely as a result of the financial crisis. It’s just that the resulting low interest rates pushed investors to pursue these strategies in greater quantity.)

It’s our belief at Beacon Wealthcare that you should divide your investment portfolio into two parts: one part, stocks, designed for growth, the other, bonds, for support. Stocks are where you take risk. Bonds are where you seek stability. Avoid the temptation to co-mingle.

This isn’t to say it’s easy to advocate for traditional bonds or treasuries as vital components of your portfolio because it’s not. There will always be a more exciting story. But, that story brings along with it an increased likelihood of underperformance.

So, what to do? First, understand what kind of bonds you are invested in and, if you are using an actively managed strategy, see if the prospectus allows the manager to invest outside of bonds into things like stocks, commodities, etc. (If the name of your bond fund has any buzzwords mentioned above, there’s a good chance it does.) Second, see how the bonds or funds you own performed during the financial crisis. If they behaved more like a stock, suffering steep losses, you may want to re-consider where you’ve put your money. In the case of Mr. Gross’s fund, you only need to look back to May 30th of this year when it was down 3% in one day!

You could also get in touch with us for a second opinion on your portfolio. We can dig deep into the risk profile of your portfolio and see how it performs under different market environments and stress tests. What’s most important is that you’re an educated investor and that you know what you own, so let us know how we can help.

 

Author Ryan Smith, CFP®, RICP®

More posts by Ryan Smith, CFP®, RICP®

Join the discussion 2 Comments

  • Steve Kurtz says:

    Good article Ryan. Probably my highest compliment on it is that while reading, I thought Sam had written it. He is a gifted, clear communicator – and now I see you are too.

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