Building Portfolios on the Road to Independence. Part II: The Role and Use of Bonds

Last week I discussed the first stage of my portfolio construction process. Clearly, this was a difficult task to complete in a 400-500 word essay as it omits many important issues from the discussion. Before I move on to this week’s topic, let me make one thing perfectly clear, I do not believe I (nor anyone else) can predict market returns. However, I do believe it’s fruitful to determine the return needed to reach the goal. Then at least you have a benchmark against which to measure your progress. This week, we will begin to build the portfolio starting with bonds (I could have said “fixed income,” but I eliminated jargon from my vocabulary a long time ago).

My Approach: Core and Stability

With bonds, I use a “Core & Stability” approach. In general, bonds are primarily affected by interest rates which will rise, fall, or remain static. The worst environment for bonds is when interest rates are rising since as rates rise, bond values fall. There are other factors which affect bonds such as money flows (with mutual funds) and credit quality, but let’s stay with the topic of interest rates. First, I avoid long-term bonds. Even though there are periods when long-term bonds outperform, over longer periods of time, the returns in this category are similar to intermediate-term bonds, but intermediate-term bonds contain much less risk (as measured by standard deviation). Next, I will typically avoid bonds with embedded options (call features). This is because of their negative convexity (a discussion for another time). Finally, I am not a big fan of high-yield bonds, but do hold them on occasion. Finally, I will normally use mutual funds of ETFs. However, I will buy some individual issues if the portfolio is large enough.

Core

Here I include intermediate-term bonds, mortgage-backed bonds, and inflation protected bonds (TIPS). If interest rates are falling, intermediate-term bonds will perform well (as will most bonds). When interest rates are rising, I like TIPS because of their increasing floor (par value increases with inflation or CPI). If interest rates are rising, the economy must be growing and CPI will be positive. Finally, in a “static” environment, mortgage-backed bonds will fare well. I should note that I use GNMA’s here, and that mortgage backeds receive the smallest allocation of the three. Currently, I am overweight in TIPS.