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Bonds and downside vs upside risk

Hi everyone,

I'm currently building my personal portfolio and targeting a 60/40 or 50/50 stock/bond split, with bonds intended to help stabilize the portfolio, as usual.

However, given the current conditions, I've started to wonder whether if bonds remain as good a diversifier as they usually are, for two main reasons:

1. Unlike in previous times, yields in developed economies (particularly in the Eurozone, where I live) are so low right now (even negative) that I think the upside potential of declining yields and price appreciation during periods of recession is very low, especially when compared with a few decades ago where yields had much more room to go down

2. As I believe Cullen has pointed out previously, lower yields mean higher convexity and therefore higher risk under the form of more sensitive duration to changes in yields

Overall, this makes me think bond risk is now considerably more skewed to the downside than to the upside, which does not seem ideal when their purpose in a portfolio is to help balance returns during bad periods.

Therefore, I ask:

  • What do you guys think of the role of bonds in your portfolio under current market and economic conditions? Are you rethinking it?
  • Given some yields (i.e Eurozone government) are currently negative or barely positive, wouldn't it be a better idea to move one's bond holdings to cash, which in some cases earns a higher return without the added risk, which appears to be almost exclusively dowside risk anyway?

Thank you.

I think you highlight some of the pertinent risks in bonds at present. It’s one of the main reasons why I think you virtually have to have a somewhat active bond allocation. A buy and hold global bond portfolio is a highly inefficient way for most people to own bonds because there are so many obvious flaws in the construction of that portfolio. You can eliminate so many of the risks in a global bond portfolio because the risks are measurable (unlike the stock market).

So yes, I think you’re wise to be somewhat selective as you go about this process.

"Pragmatic Capitalism is the best website on the Internet. Just trust me. Please?" - Cullen Roche
Quote from Cullen Roche on 11/25/2019, 10:47 AM

I think you highlight some of the pertinent risks in bonds at present. It’s one of the main reasons why I think you virtually have to have a somewhat active bond allocation. A buy and hold global bond portfolio is a highly inefficient way for most people to own bonds because there are so many obvious flaws in the construction of that portfolio. You can eliminate so many of the risks in a global bond portfolio because the risks are measurable (unlike the stock market).

So yes, I think you’re wise to be somewhat selective as you go about this process.

Thank you for your reply, Cullen. What obvious flaws would you be referring to?

My current (and only) bond fund is precisely a global IG bond fund hedged back to EUR (ishares core global aggregate bond); a common recommendation by the folks over at Bogleheads for those based in EUR and looking to get global bon exposure without currency exposure.

I think a lot of people (maybe even most) mismanage their bond portfolio and actually oversimplify them to the point where it hurts their returns. For example, in the USA I'd point out several flaws with using something like AGG (the Bond Aggregate) which is very common as a single holding for someone's "bond" portion. This is almost always a mistake for the following reasons:

1) It has no exposure to the muni and high yield space which substantially reduces its after tax returns.

2) It's mostly a short duration T-Bond fund which doesn't even provide significant uncorrelated bond returns in a low interest rate environment.

3) It's  static index fund so it actually exposes you to procyclical interest rate risk meaning that it will become more overweight riskier bonds when they become riskier.

4) Holding the single fund reduces tax efficiency further by eliminating the opportunity to harvest losses in other bond funds across time.

I will only hold this fund as a complement to other bond funds in a portfolio. Holding this fund as your only bond fund is, in my opinion, a very bad way to manage a bond portfolio and it reduces many people's returns by upwards of 1-2% per year because they make their portfolio too simple....As you likely know, I am a big big fan of indexing, but it can be taken to an extreme where people choose the lowest fee funds and reduce their number of holdings to the point where they're actually hurting their returns. Holding one bond fund like AGG is a perfect example of oversimplifying to the point of making your portfolio worse.

Hope that helps.

"Pragmatic Capitalism is the best website on the Internet. Just trust me. Please?" - Cullen Roche