What plunging equity prices say about bonds as a hedge for stocks

Brooke’s Note: When we feel sick, we seek modern medicine’s most sophisticated drugs. When we feel financially ill, we want sophisticated hedging techniques. But a balanced diet solves most physical ills and a balanced portfolio does the same for long-term financial well-being. Here’s an article that reminds intelligently of exactly what that means in light of the recent days of investing trauma.

The last several days have put advisors right in the middle of a possible perfect storm with uncertainty in both the equity and bond markets.

Equity prices have already plummeted. Rates continue to hover at historically low levels, delivering short-term returns but leaving bond fund investors waiting for the other shoe to drop if rates rise.

The last time we saw investors with no safe haven for returns was in 1969 when the S&P 500 was down 9.5% and the 10-year Treasury index was off 5% for the year.

Lurching to annuities

As usual, when markets are volatile and uncertain, investors look for ways to protect the downside. Variable annuity companies prey on clients looking for the Holy Grail of market returns with downside protection.

What is it they say about stories that sound too good to be true? See: An inside look at why LPL Financial is leading the charge with fee-based variable annuities.

Others look to hedging strategies to provide a kind of market loss insurance policy. In the long run, unless you have a crystal ball that signals market declines, the cost of the “premium” systematically erodes any benefits. Some hope that stop losses will provide a golden parachute when they bail out of the market.

Unfortunately, with that kind of timing strategy, you have to figure out when to get back in as well. Between false sell signals and lost opportunities on quick rebounds, stop losses keep investors out of the market and often lead to missing the “best days” that deliver the lion’s share of the market’s returns.

It turns out that the simplest approach to managing downside risk may be the most effective. It really starts with asset allocation. The most important decision is how much capital an investor is going to put at risk. Determine the split between the predictability of individual bonds and the higher risk and reward of equities that get clients the best chance of reaching their goals.

Bifurcating the client brain

The key to managing the downside is keeping the bond and equity portfolios separate in your client’s mind. This approach takes advantage of behavioral finance concept of mental accounting that reflects how people compartmentalize their money for different purposes. Each portfolio is going to serve a different role.

Bonds will provide near-term predictability over a number of years and equities will provide long-term return but will need time to manage the downside. You build a predictable bond portfolio to give your clients the comfort to ride through what can be several years of recovery from a decline in equity markets. You build an equity portfolio that will, given time to recover, provide higher long-term returns. Mix equities and bonds up in a total return blender and you lose the distinctive characteristics than make it work.

It sounds simple, but there are some real factors at work. At the center is something called time-segmentation. It reflects something you may have felt intuitively. Different assets behave differently over various time horizons. Consider the difference between a 5-year Treasury bond and the S&P 500.

Yesterday a five-year Treasury bond could be bought with a yield to maturity of about 1.1%. Dismal, right? But in five years, the 5-year bond will mature having delivered 1.1% return even if interest rates have risen dramatically. The worst case returns are known, predictable, and positive. The S&P 500, on the other hand, has an expected compound return of about 10% but a potential downside of -18% over five years (using monthly data back to 1926). Positive 1.1% starts to sound pretty good when compared to an 18% loss.

Bonds for the short run

The bull market in bonds over the last 30 years has lead to a generation that has almost forgotten why investors used to buy bonds. Stability? Yes. Income? Yes. But the thing that bonds do best is provide predictability and downside protection. When you buy a high quality bond, you know the timing and amount of the coupon payments and redemption. No need to forecast or guess. The cash flows are perfectly predictable. And if rates rise, what’s the downside?

The yield to maturity (YTM) was on the bond when you bought it. You don’t have to sell when the prices fall and take the loss. Just continue to receive the coupon payments and get the face value back when the bond matures. Unlike almost any other asset, the return is positive, even in the most challenging market conditions.

Let me be clear. When I say bonds, I mean individual bonds, not bond funds. They are two distinct financial instruments. An individual bond is a legal obligation of the issuer to pay periodic coupon payments and return the investor’s principal at maturity (or just the principal in the case of a zero coupon bond).

A bond fund is a mutual fund. Although it happens to invest in bonds, the fund itself has no legal obligation and because of turnover within the fund, the certainty of payments and ability to protect the downside are broken. That is why bond fund managers and individual bond separate account managers often view the same bond market in very different ways.

Downgrade is non-issue unless…

The downgrade of the US debt at this point is really a non-issue unless you believe that the US government will not eventually take the steps needed to bring the debt under control. At some point, the political pain of not taking action will be greater than enacting the tough measures that will be needed. The S&P downgrade helped shift more of the weight toward action, but we aren’t at a tipping point yet. If you don’t think that will ever happen, then you’ll have to look to Lichtenstein and Norway for your safe investments. Otherwise, you’ll just have to stipulate that the US will continue to muddle through without a default.

Will the downgrade cause rates to rise? Unfortunately interest rates are notoriously difficult to forecast. A great example is the panel of economists in the Wall Street Journal. Let’s just say that you are better off asking a coin to forecast the direction of Treasury bond rates, and this is a group of some of the best and brightest economic minds. It’s just a crap shoot. You might think that all the turmoil around the debt ceiling and downgrades would cause rates to rise. If the last couple of weeks are any indication, the market disagrees with the S&P and continues to find high quality US bonds to be a safe investment.

Equity markets are streaky. The average annual premium of equities over bonds has been a little more than 6%. Average annual return on the S&P 500 from 1926 through 2010 was about 11.2% and yet compounded total return was around 9%. That indicates a lot of volatility. Setting aside the normal distribution debate for the purpose of discussion, standard deviation was 19.6% meaning the upward boundary was 28.9% and the bottom boundary was -10.3%. There is about a 1 in 3 chance that a given year will have a loss. Sometimes a big one. But in the long run it still pays to have equities if you need return greater than what bonds are paying. The returns just aren’t predictable.

Time is a greater hedger

One of the best hedges against equity losses is time. By controlling near term downside in the bond portfolio, investors can build a time buffer to ride out market losses in their equity portfolios. So far, we have always seen markets recover from their drawdown. The table below shows the drawdown and recovery statistics for the S&P 500 starting as far back as 1926. The longest recovery period started with the crash in 1929 and took more than 15 years to come back. Excluding the Great Depression and its drawdown of -83.4%, the longest period has been 6.58 years. On average, it only takes about 2 1/2 years to recover. That means that a bond portfolio with staggered maturities of up to 7 years can provide a time buffer long enough for most bear markets.

Telling numbers: the drawdown and recovery
statistics for the S&P 500 starting
as far back as 1926.

Buy and hold seems so boring. There must be a better way. It is markets like this that usually rehash stories of the death of buy and hold. The evidence continues to pile up to the contrary.

Market timing and hedging prove to be expensive and eat into returns over time. By simply disaggregating bonds and equities to serve different functions within the portfolio, natural time segmentation will provide downside protection within their relative horizons. Hold bonds for when equity markets are bad to help provide time to recover. Hold equities for the long run and give them time to deliver their higher expected return.

Brent Burns is president and a founding partner of Asset Dedication LLC, a fixed income separate account manager.