Creative Planning

The case for bonds

Peter Mallouk, J.D., MBA, CFP Chief Investment Officer www.thinkingbeyond.com

Wealth management UPDATE June 2nd, 2013

The financial media is abuzz with news of the demise of bonds as an asset class. Recently, we wrote of the impending bond bubble which covered our thoughts on rising rates and their impact on bond prices. Since then, Warren Buffett has advocated for holding very small bond positions and Bill Gross, who manages more bonds than anyone in the world, has again declared the long bond bull market over. There is much agreement that with interest rates expected to go higher over time, bond returns will be lower than they have been over the past 20 years. If that is in fact the case, why own bonds at all? While financial media is telling story after story about the move from bonds to stocks, what they are calling The Great Rotation, the reality is that it has not happened yet. Believe it or not, money is still flowing into bonds at a torrential pace, with bond funds averaging net inflows of approximately $6 billion a week (Lipper, May 2013). For all you may be reading about investors not liking bonds, it turns out the numbers tell a different story. Investors have several reasons for allocating a portion of their portfolios to bonds. Bonds dampen portfolio volatility. Most investors, especially those with considerable funds invested, simply cannot tolerate large drops in their portfolio. Many investors have vivid memories of the tech bubble and 9/11 market aftermath, with the S&P 500 dropping 49% from its high, or the recent financial crisis when the market dropped 53%. As recently as late 2011, the US market dropped 19.6%. In all four cases, small and foreign companies actually performed even worse than the S&P 500, which represents only large US companies. These events are sometimes fleeting, such as in 2011 when the market recovered within months. However, it is not uncommon for a bear market to go on for quite some time, such as the tech bubble and 9/11 bear markets, which combined lasted over 30 months from top to bottom, or the recent financial crisis that lasted 18 months before the markets recovered with a vengeance. While it is easy to simply say every bear market will give way to a bull (they always do), for many investors it is an entirely different thing altogether to live through a full blown bear market without any buffering of the full impact. Most of the time bonds behave quite differently than other asset classes.

3400 College Boulevard Leawood, KS 66211 913-338-2727 Fax 913-338-4507 Website: www.thinkingbeyond.com E-mail: cpi@thinkingbeyond.com

Creative Planning

The case for bonds

A common theme of investing is to invest in several different asset classes to increase the probability of obtaining the target return with the least volatility possible. When we build a clients portfolio, we examine each asset class to determine if it is appropriate for their particular situation, including considering the inclusion of stocks, bonds, real estate, commodities and alternative investments such as MLPs. If you own any or all of these asset classes, it is because we believe their inclusion increases the probability of getting you the return you want to achieve. Bonds, though, stand out among the pack. While each asset class behaves a little differently, bonds are the only asset class that moves its own way the majority of the time. For example, in all the aforementioned bear markets, stocks, real estate, energy and MLPs were hit hard. In other words, they all behaved very much like stocks. In each of these cases, however, our bond positions not only did not get hit, they actually increased in value. While bonds do not always go up when the other asset classes go down, they often do, so they not only buffer the portfolio when the other markets are hit, they actually contribute to the return. If the alternative to bonds is cash, no thanks. Some argue for simply owning a portfolio of stocks and cash. We advocate against this because we are not in the business of guaranteeing the loss of money. Cash yields are less than the rate of inflation, guaranteeing that a cash position will lose the investor the real value of their money over time. Cash is just ahead of gold as one of the worst investments of all time, and the more time a client spends with a portion of their portfolio in cash, the greater the odds they wont achieve their objectives. For this reason, we propose bonds as an alternative to cash. Not all bonds are created equal, and if an investor is concerned about rising rates, as we are, he or she can simply avoid long term bonds and shorten the duration of the bond portfolio as their cause for concern increases. Bonds allow an investor to avoid being at the mercy of the stock market. Many investors have a purpose for their portfolio, usually requiring certain funds from the portfolio over periods of time to meet the households need. Lets take, for example, an investor retiring in a year with a $2 million dollar portfolio who needs about $100,000 per year to maintain her familys lifestyle. The inclusion of bonds will provide income and increase the probability that the investor will have a portfolio that can sustain her needs over the short and long run, regardless of the timing of any stock market corrections or bear markets. If the investor were 100% stocks and a bear market started a few months later, the portfolio could easily be cut in half, all but guaranteeing that the investor would run out of money quickly or forcing the investor to spend less for the rest of her life. If, however, the portfolio held, say, 30% bonds, the investor would be able to maintain the distribution
3400 College Boulevard Leawood, KS 66211 913-338-2727 Fax 913-338-4507 Website: www.thinkingbeyond.com E-mail: cpi@thinkingbeyond.com

Wealth management UPDATE June 2nd, 2013

Creative Planning

The case for bonds

required from income then from selling the bonds themselves, allowing the stock portion of the portfolio time to recover at its own pace. Our clients did just that, among other positive steps, in 2008 and 2009. This is one of several reasons our average client portfolio hit an all time high sometime between 2009 and 2011, not when the S&P 500 did in 2013. For many investors, bonds provide a very tangible solution to concerns about short term stock market movements, whether they be for months or years. Wealth management UPDATE June 2nd, 2013 Bonds provide funds that allow an investor to seize opportunities. In this letter, we have discussed 4 recent bear markets, but there have been many corrections as well, averaging more than one per year. A correction is any market drop of 10% or more, and the average correction is a drop of 14%. Bonds provide the disciplined investor a pool of accessible funds to seize these opportunities. At Creative, we aggressively buy during market drops, a strategy called opportunistic rebalancing. To buy, there must be money somewhere, and the best place for it is in bonds. Dont read us wrong; for the long run portion of your portfolio we still prefer stocks. While there are many reasons to own bonds, let us be perfectly clear. It is our expectation that stocks will outperform bonds over the next 10 years and almost certainly over the next 20 years. This is simple math given the current income provided by stock dividends compared to the current yield of longer term bonds (more on this in a letter coming soon). If your goal is to have the biggest pile of money possible 10 or 20 years from now, and you are willing to take a very dramatic ride to get there, then you should own just enough bonds to seize opportunities, if any at all. If this is you, and you currently have more than 20% bonds in your portfolio, then your portfolio should be revisited now. If however, your goal is to create the income or return you need or want with the least volatility possible, then bonds play a very significant role in your portfolio, and can be held for any of many good reasons to own this asset class. We continue to watch the bond market and interest rates carefully, and are consulting with many of the countrys top bond managers. It is our expectation that we will be making more changes to our bond allocation in the near future. As has always been the case, our objective will not be to eliminate bonds as an asset class, but rather to control the interest rate risk as much as possible. There are many good reasons to own bonds, and for some there are good reasons not to own them. Like all asset classes, bonds are not good or bad. They are simply either appropriate or they are not. At Creative, we make it a priority to know your situation and objectives so that we can advise you accordingly.
3400 College Boulevard Leawood, KS 66211 913-338-2727 Fax 913-338-4507 Website: www.thinkingbeyond.com E-mail: cpi@thinkingbeyond.com

Creative Planning

The case for bonds

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Wealth management UPDATE June 2nd, 2013

3400 College Boulevard Leawood, KS 66211 913-338-2727 Fax 913-338-4507 Website: www.thinkingbeyond.com E-mail: cpi@thinkingbeyond.com