Bonds as a stabilizer

This is a guest post from Bogleheads® forum member Nisiprius,  published August 14, 2011.

It’s often debated whether we can expect to get the “historical rate of return” for an asset class going forward, but let’s not get into that.

The historical rate of return for the S&P 500 has been roughly 10% per year; for intermediate-term bonds, 5.5% per year.

That’s per year.

Historical Risk/Return – Bonds Historical Risk/Return – Stocks
Average annual return 5.50% Average annual return 10.10%
Best year (1982) 32.60% Best year (1933) 54.20%
Worst year (1969) –8.1% Worst year (1931) –43.1%
Years with a loss 14 of 90 Years with a loss 25 of 90

If you figure about 200 trading days per year, that means the average return for stocks is 0.05% per day, yet the stock market often fluctuates 1% or more on any single day. The average return for bonds is 0.026% per day. The whole point of your investments, their long-term earnings, are not going to be visible day-by-day–they’re going to be completely masked by the short-term volatility of the markets.

You may be unfamiliar with the behavior of bond funds. A general-purpose intermediate-term bond fund like Vanguard Total Bond Index Fund (VBMFX) is not going to behave like a money market account or a bank account. Here’s how money would have grown in VBMFX versus a money market account.

bondsvscash

Notice these things:

  •  The money market fund, like a bank account, moves one way only: up. It moves up at different speeds from time to time, sometimes slowly (flat sections), sometimes quickly (steep) sections, never down. The bond fund does not. It generally rises pretty steady but there are definitely some downward fluctuations. Notice particularly the area around 1994, a 4% dip, and, more recently, about a 2% dip in 2011.
  •  Think about what a 4% downward dip means (as in 1994). It means that several years’ growth can be wiped out in a few months. However, it is quite different from the shock of a 50% drop in the stock market.

So, you should expect your bond funds to fluctuate; they’re not like bank accounts. You should not be terribly surprised to see, let’s say, a 5% loss over a period of a year. You’re hoping to get more than you get in a cash investment, but you can put in $10,000 at the beginning of the year and see only $9,500 at the end of it.

You are balancing risk against return. Over the 25-period shown, we are talking about the difference between growing $10,000 to $28,000 in a money market fund–other safe cash investments wouldn’t be very different–or $50,000 in the bond fund.

Are bonds a safe place for your retirement savings?

Safety is all relative. Vanguard calls VBMFX “risk level 2” and says “In general, such funds may be appropriate for investors with medium-term investment horizons (four to ten years).” They of course qualify it with a “may” but they are implying it’s pretty safe if you won’t need the money for at least ten years, because that’s usually long enough for the growth from reinvested interest to overcome any downward fluctuations that might occur.

In contrast, Vanguard calls its less-risky stock funds “risk level 4” and says they “are subject to wide fluctuations in share price… may be appropriate for investors who have a long-term investment horizon (ten years or longer).”

Like a cash investment, VBMFX is an investment in “nominal” bonds. All the statements about loss and recovery refer to numbers of dollars. Inflation is potentially serious to bond holders; in that sense, bonds are not so safe. This is why many Bogleheads favor an allocation to TIPS, as represented by the Vanguard Inflation-Protected Securities Fund, VIPSX.

VBMFX invests in strongly-rated “investment grade bonds.” A bond is (typically) a loan of $1,000 to a corporation or to the Treasury, which pays you back regular interest payments for the term of the bond, then pays back the $1,000. Unlike a stock, which is a sort of share or partnership in a business, a bond is a specific promise to pay agreed-on amounts. “Investment-grade bonds” are from reliable issuers who, the ratings agency judges, are well able to afford the loan and will almost certainly pay it back. That means that virtually every bond in VBMFX is going to pay back the loan within a known period of time–average about 7 years for VBMFX. In that sense, it is pretty safe against long-term dollar loss. Unlike stocks, there is good reason to believe that the dollar value of VBMFX will recover from downturns and that losses will be temporary. 1994 is not a worst-case scenario but it was a very severe event in the bond market, and you can see what happened.

Here’s one more way to look at risk. This is a price chart for VBMFX. Suppose you simply spend the dividend payments from the fund instead of reinvesting them. The dividend payments represent the source of long-term growth for the fund; the price fluctuations represent the short-term effects of the market. If there were no market fluctuations, every bond in the fund would always be exactly worth its $1,000 face value and the market value of the fund should be perfectly stable. Asking whether a bond fund is “safe for retirement savings” is basically asking whether the price and NAV of the fund are holding up stably over time.

A money market or bank account, if you withdrew the interest as it accrued, would just sit there and hold precisely the same number of dollars all the time. The chart below  shows what VBMFX did. NOTE: This is a price chart, without reinvested returns.

vanguardtotalbondfund

The short-term fluctuations up and down, within perhaps a 10% band, illustrates the short-term risk of the bond fund. The fact that the long-term behavior is more or less flat indicates the relative safety to a long-term holder. The flatness and relative safety of the bond fund become clearer if we plot it together with a similar price chart for a stock fund:

bondfundvsstockfund

About

Barry Barnitz, administrator of both the Bogleheads® wiki and of Financial Page, a Bogleheads® blog

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