Posted by admin on July 3, 2010 | No Comments
Generally, I prefer to pick individual equities rather than go with asset allocation. Still, sometimes asset allocation is the only choice available. Recently, a client asked me to take over a 529 plan, and in these situations, asset allocation is the only option. In this situation, most investment advisors just determine their allocation, invest fully and let things sit. This has led to terrible results over the last decade. I believe, even with asset allocation, that the investor has to try to time the cycles, and exit whenever serious downturns occur. That means exiting equities in 2000, when the dot com boom went bust; in late 2007 to early 2009, during the credit crisis; and in May 2010, when the market corrected. Then the choice would be whether the investor should be in cash or bonds. I should note that this line of thinking is radically different from traditional asset allocation practices.
Let’s take a look at a couple bond funds and at history to see if we can find any patterns. In this exercise, I’m using the funds available in the TD Ameritrade 529.
First, let’s establish a baseline for comparison. Let’s start with the S&P, as well as the Fed Funds rate. This way, we can compare the performance of various bond funds with what was going on in the market and with interest rates.
So let’s look first at the Vanguard Short-Term Bond Index (VBIRX). If you compare this with the Fed Funds rate chart, you’ll see that this is essentially the inverse of the Fed Funds rate. The only exception is the late 2008 period, and I’m guessing that, at that time, the bond fund managers didn’t have time to adjust to the market dip in October 2008, and so the portfolio took a hit during that period. Eventually, they did (I’m guessing), and the bond fund continued its upward trend into 2010, inversely correlated with interest rates. This does imply that we are in a bond bubble driven by record low interest rates, and that the VBIRX will reverse as soon as the Fed Funds rate increases. In all likelihood, that will happen in late 2010. By the way, the yield on this short-term bond fund is 2.58%.
The next bond fund is the Vanguard Intermediate Term Bond Index (VBILX). To me, this looks just like the short-term bond fund chart, only less extreme. So there’s two ways to think about this. If you’re going to play the long-term trend and the interest rate cycle, then its best to play the short-term fund because it gives you greater volatility. So if you can catch the cycle near the top or bottom, you’ll maximize the benefit from the change in price. Alternatively, this is more stable and actually provides a 4.34% yield. So you could think about just holding and collecting the higher yield. Still, looking at this chart, it’s traded between $10 and $11.20, which is more than a 10% swing in price. So I’d argue it’s better to be active an to play the swings. While this may be optimal, it does require attention and work. Most investment advisors prefer to be passive and just hold.
And finally, let’s look at the very popular PIMCO Total Return (PTTRX) and the Vanguard Total Bond Market Index (VBTIX). In fact, the charts of these two funds look identical. These charts are roughly similar to the VBIRX and the VBILX, except that during the 2003-2006 period when rates were rising, the funds were actually relatively stable. I’m assuming that’s because these funds are geared for higher return, which implies a longer duration and perhaps more higher-yielding bonds.
Conclusions. Looking at these charts, here’s the patterns that I see:
- 1998-2000. During the tech boom, the bond funds (the PTTRX and the VBTIX, don’t have enough information for the Vanguard short and intermediate term funds) fell while the market was soaring. Interest rates were being raised to slow down the boom. So increasing interest rates, good stock market means declining bond funds.
- 2000-2003. Both the PTTRX and the VBTIX rise as the economy goes in the tank and interest rates fall. Bad economy, falling rates, bonds rise.
- 2003-2006. The short-term and intermediate-term funds fall as the market rises and interest rates rise. This is the same as the 1998-2000 pattern – good economy, rising rates, bonds fall. The PTTRX and the VBTIX remain relatively stable for most of this period and then start to fall during the end of this time.
- 2006-2007. All the funds trade within a small range as interest rates plateau and the market tops (hey, maybe the bond market is telling the equity market that the top is here!).
- 2007-2010. A rise from 2007 to 2008, followed by a dip in late 2008 (the crash), and a continuation of the uptrend after. Interest rates head straight down for the period, while the market has the big dip in October 2008. It seems that interest rates dominant the trend, but the bond funds still get hit by the troubles in late 2008. This implies interest rates are the primary driver, but short-term volatility in the markets can supersede interest rates for a (relatively) short period of time.
Going forward, it seems that the bond funds should stay relatively stable while interest rates stay low, and rates are likely to stay low until the end of 2010. Still, with the 10-year trading at less than 3% (really low!), an uptick there could cause bond funds to fall. Plus, we do seem to be in a bond bubble, so if fears stabilize and the economy recovers, that could be the beginning of a sustained downward move for bonds. We have a short window to be in bonds, anywhere from 3-9 months is my guess.
