Bond portfolio choice for our high income family – A weekend at Bernie’s

Bond choices are plentiful: treasuries, municipals, corporates, junk.  Bond durations vary: ultra-short, short, intermediate, long.  Bond packages abound: mutual funds, ETFs, individual, ladders  As a high income family we have specific needs from bonds, but what to do?

We’ve been wrestling with the decision to buy bonds for about 3 years.  We had an all stock portfolio which was doing great thanks to the giant bear market. I had done my homework though, we needed some bonds for all the right reasons: diversification to equities, psychological ballast during market downturn, “dry powder” (William Bernstein) for buying stocks in a  bear market or buying whatever.

But bond are just not sexy right now…. at all, right?

Bonds funds in our qualified accounts were yielding near negative returns thanks to expense ratios around 0.75-1% and low yields from the Federal Reserve Quantitative Easing program after the Great Recession.  We struggled for a while to even pull the trigger on bonds.  Once it was done, it was like taking off the band aid, it just hurt for a second.  Our bonds are now yielding a modest but steady stream of income which is compounding.  How we came to the decision of bond type is the subject of this post.

There are as many recommendations for bond types as there are authors commenting on the subject.  I’m a huge fan of William Bernstein, the physician/scientist turned financial adviser.  Dr. Bernstein advocates intermediate-term US treasuries for the bond portion of a portfolio.  He argues that the “sweet spot” of the yield curve is in the intermediate range of maturation, ie around 5 years.   Shorter duration give poor yield and longer is more prone to interest rate risk.

Ok fine, so I need some intermediate treasuries.  Choices in our qualified accounts were poor plus I like the Roth IRAs to have REITs and needed all that space for the REITS.    So the bonds were going in the brokerage.

Treasuries are taxed by the federal government as income at your marginal tax rate (state tax exempt). That means the higher tax brackets for a physician family.   Not such a big deal considering the very low yields currently payed by intermediate treasuries.   Here is the yield as of this post info on Vanguard Intermediate Treasuries Mutual Fund Admiral Shares (VFIUX). Note the SEC yield 1.78%.   I love how the 10 year yield hints at the normal times; maybe this is the new normal??


VFIUX July 2017

 Assuming this low yield for the foreseeable future, my tax implications wouldn’t be that bad.  I would need a million in the fund to generate $20,000 in gains taxed at around 35% for a $7,000 tax bill per year if held in brokerage.  I didn’t plan on being at a million for a least 10 years so taxes weren’t a deal breaker.

Municipal bonds at this time are yielding favorable (thats the treasury to muni spread) to compared with Treasuries of similar duration.   Current  SEC yield 1.86%, that’s higher than treasuries!  As Munis are exempt from federal tax, buying Munis was a no-brainier for me in the higher tax brackets.



That of course, is not the end of the story.  Why, do you ask, not just put the whole bond portion in Munis?  Well, there are more functions of bonds in a portfolio than just yield.  I touched on a few in the first paragraph and a full discussion is beyond the scope of this post.  However, in summary, bonds provide diversification to equities, psychological ballast during market downturn,  “dry powder” (William Bernstein) for buying stocks in a  bear market or buying whatever, and others.

So I knew that I need bonds to not crash in a downturn.  Once that requirement was known I could better make a decision as the the type of bond needed.  This reason is why I don’t buy corporate or high-yield junk bonds.   Those types tend to trend with equities in a market downturn.  The very characteristic I need in bonds.   This is why I avoid the Vanguard Total Bond Fund.  It has corporates (and a healthy dollop of long-term bonds which I don’t particularly want.)

How we made the choice between Munis and Treasuries

First, I wanted to compare the returns of the 2 funds against each other and against the market.  The graph below is Morningstar’s comparison rolling 12 month returns of my 2 bond funds of choice and the total stock market fund, all Vanguard.   If using the link above, you might have to add the fund ticker symbols to the chart and select 12 month rolling average.

Its so tiny so let me tell you:  Blue is Treasuries VFITX, Orange in Munis VWITX and Green in Total Stock VTSAX.
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It shows there is a less than perfect correlation (one goes up, the other down) at various times between stocks and each bond fund and maybe some poor correlation between the bond funds.
Below are the correlation coefficients of the funds since inception.   (link here if you want to mess with it, just enter as I have).  I used the years 2001 until late 2016 when I bought the bonds.
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Treasuries VFITX,  Munis VWITX, Total Stock VTSAX.
As you see, both bond funds are poorly correlated with the stock fund, although the treasuries are less correlated than the munis  (thus, treasuries may provide better diversification to a majority stock portfolio).  Also interesting is that the bond funds aren’t well correlated, therefore, holding each may provide some diversification and therefore higher returns, the whole modern portfolio theory thing (less than perfectly correlated assets provide risk adjusted return superior to blah blah blah, you know…..)
But I wanted to know how these performed when the market was down, ie when I needed bonds the most.  Below are the correlation coefficients of these funds plotted during the last financial crisis, the Great Recession.  I couldn’t go further back in time than the Great Recession because these 2 bond funds didn’t exist.
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As you see the treasuries are poorly correlation with stocks and the munis are well correlated with stocks in a crisis.  Not good for munis.
Here is another way of looking at the data.  Below is from the prospectus of the munis and treasuries.  Note the high return of the Treasuries during the Great Recession.  10% ain’t bad!  Remember stocks went down 30-40% or more.  It took a few years for them to recover while the bonds were sitting pretty for years, Munis included although not quite as sweet as Treasuries.
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A post mentioning correlations wouldn’t be compete without the caveat Past returns to not guarantee future performance.  I get it… But I needed something to break the tie between all of the advice out there!

Take home points: 

  1. Both bond funds provide diversification over stocks
  2. Treasures are less correlated with stocks over the entire time period (in the past)
  3. In a crisis, Treasuries are poorly correlated and Munis are well correlated with stocks.  Crisis is one of the more valuable times to have bonds for a variety of reasons as mentioned above
  4. The 2 bond funds are not well correlated with each other, thus having both may add diversification (and a mild degree of increased portfolio complication)
The plan is to thus have both bond funds in a 3:1 ratio Munis:Treasuries.  If the Muni yields continue to fall, I can always add more Treasuries by selling the Munis.  As our tax bracket is so high, the Munis will have to fall and the Treasuries would have to rise quite a bit before that occurs.  Given the rising rate environment, the selling shouldn’t generate too much taxable capital gains because rising yields will drive prices down on my current shares.  (Yes capital gains from bonds are subject to tax).
As a DIY investor I’m prone to error and this may not be the best strategy, but it makes sense to me.

4 Replies to “Bond portfolio choice for our high income family – A weekend at Bernie’s”

  1. I am nearly 100% equities. Mostly S&P, but a high dividend aristocrat ETF too, yielding 3.25%+. I have enough rental income that I should never need to sell, and my dividend income is enough to live on.

    My Fidelity account rep always wants me to have more bonds, but you only need bonds to stabilize a portfolio.

    1. Interesting portfolio approach with equities and real estate. Seems the passive income from your rents in acting like some bond income. I agree that bonds do stabilize a portfolio. Along those lines bonds allow for better risk adjusted returns. For example, comparing a 90/10 stock bond to an all stock, the portfolio with bonds may have a slightly lower return but will have a lower standard deviation (risk) than the all equity portfolio. Typically, the decrease in risk is bigger than the increase in return, so the risk adjusted return (return divided by standard deviation) increases by adding bonds. So I can get more return from lower risk with bonds, but at the cost of a lower overall return. Like you say, the stability helps me sleep better : )
      Its like William Bernstien says, “Happiness is a warm bond”.

      Id be interested to know how your portfolio would fare in a big market downturn. I dont know how actual real estate correlates, except in the Great Recession of course when it fared poorly I believe. Maybe adding some bonds would help stabilize things for you when the next correction comes. Or maybe real estate will go up and you’ll be sitting pretty. How did your real estate do in 2008-09?
      Thanks for the comment.

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