Do you really need bonds in your portfolio? That is a reasonable question to ask, particularly at a time when interest rates are low. Income from bonds is minimal so the incentive to hold non-equities is lower than normal.
The answer to the question is somewhat dependent on the age of the investor, but even then, bonds may not be required. For example, suppose you are receiving a $1,500 social security check each month. This monthly income is backed by what I call a “bond equivalent.” By “bond equivalent,” there is money, or a promise of some sum of money, generating that monthly income and it is backed by faith in the U.S. government. Although we don’t consider this “bond equivalent” as part of the portfolio, neither should it be neglected in your portfolio analysis.
How do we evaluate the “bond equivalent?” William Bernstein, in his excellent book, The Four Pillars of Investing, writes the following.
“…if you are one of the vanishing number of individuals lucky enough to be getting regular fixed pension, then you own, in essence, a bond issued by your former employer. If that employer was the government, you can capitalize (that is, discount) its payments by a low rate –say 6%. So, if you are relatively young, you essentially own a perpetual annuity, similar to prestite and consols. If your payments are $30,000 per year, this is the same as owning a long bond with a value of $30,000/0.06 = $500,000. If you are older, its value will be commensurately less. Your Social Security payments should be capitalized in the same way. If your pension comes from Trump Casinos, I’d capitalize it at much higher rate–say 12%–making its present value only $250,000 ($30,000/0.12 = $250,000). In any case, it would not be a bad idea to increase your stock holdings to reflect the “bonds” you effectively own via your pension and Social Security.”
Coming back to that $1,500 income from Social Security each month. That amounts to $18,000 per year and using Bernstein’s capitalization calculation of $18,000/0.06, we have a “bond equivalent” of $300,000 in the “bank.” To carry this further, I know an individual who is one of the vanishing number to have a pension that pays approximately $4,500 per month or $54,000 per year. Once more, using Bernstein’s calculation, $54,000/0.06 = $900,000. If this person also collects Social Security it makes little sense to hold bonds in a portfolio.
I have developed this model in PV.
g Model
Relative Strength
Start Year
1985
End Year
2016
Tickers
FMSFX FBNDX FNMIX SPHIX FTBFX VIPSX FIBAX EMB FAGIX TLH RPIBX PFODX PCY
Performance Periods
Multiple Periods
Period Weighting
Weight rank orders
Assets to hold
2
Risk Control
Use Moving Average
Risk Window Period
6 months
Trading Frequency
Monthly
Benchmark
None
Timing PeriodsLengthUnitWeight
Time Period #1Period 1 length
3
Period 1 time unit
Months
Period 1 weight
35
%
Time Period #2Period 2 length
4
Period 2 time unit
Months
Period 2 weight
35
%
Time Period #3Period 3 length
Period 3 time unit
Months
Period 3 weight
0
%
Volatility PeriodVolatility period length
1
Volatility period time unit
Months
Volatility period weight
30
%
The results are
Market timing results from 2009 to 2016 based on relative strength model holding the top 2 best performing assets. The model uses multiple weighted performance windows to rank the assets by weighted average of rank orders including negative ranking by volatility. Risk control based on 6-month moving average is used to keep assets in cash if their price is below the moving average. Note that the selected year range for the timing test was automatically adjusted based on the available data for iShares J,P. Morgan USD Emerging Markets Bond ETF (EMB) (2008-2016).
Performance statistics for the timing portfolio and benchmark portfolios
Portfolio Initial Balance Final Balance CAGR Std.Dev. Best Year Worst Year Max. Drawdown Sharpe Ratio Sortino Ratio US Mkt Correlation
Timing model saved as ‘Bond 2’. Manage saved models »
Timing Portfolio $10,000 $25,470 13.12% 7.09% 51.66% -1.47% -4.57% 1.74 4.56 0.36
Equal Weight Portfolio $10,000 $17,860 7.95% 4.64% 22.17% -2.92% -6.30% 1.66 3.31 0.46
At sharp ratio of 1.74, and 13% backtest return looks good compared to many stock models
Anand,
Have you tried this model with another set of tickers? I’m thinking of an out-of-sample type of test.
Lowell
Yes I am generally using two momentum and one volatility to rate the funds.
Two funds add safety. Just about all combinations of bond funds can generate 10% returns.
The TLT is not a good fit. It has too much volatility.
tickers
FHIGX FMSFX FBNDX FNMIX SPHIX VBMFX VIPSX VWESX VFITX EMB JNK TLH RPIBX PFODX PCY
Have good returns also. about 10% cagr
4 month momentum has best results.
Is this too much data mining?
Thanks
Anand
Anand,
I went through the list of mutual funds and in general they have high expense ratios. Many range in the 0.40 to 0.45 zone and a few are higher than 80 basis points. That is always a concern. What I would do is to try to find some ETFs that match the asset class represented by the fund and then see if you can uncover lower cost securities. Then test the model with this new set of securities.
As for bonds generating a 10% return, remember that interest rates have been falling since the late 1970s. That is going to stop at some point. In other words, I think the best days for bonds and bond funds are over. Just my opinion.
Lowell