A Diversified Two-Fund Fixed Income Portfolio Example
Nobody pays any attention to bonds. Sure, most investors own a bond fund or two and fixed income investments have long been the mainstay of conservative income portfolios, but bonds just don’t have the cachet that equities do. Armchair investment managers everywhere routinely spend hours determining just the right mix of foreign and domestic stocks, large-caps and small-caps, developed and emerging markets. But when’s the last time you heard of anybody agonizing over their fixed income portfolio?
Newsflash: fixed income portfolios are every bit as important to long-term stability and returns as stock funds, and there are unfortunately almost as many fixed income products as there are equity funds out there.
Being a Boglehead, you might initially assume I would jump onto the Total Bond Market Index (VBMFX) bandwagon. But I neither invest in nor recommend this fund for two reasons:
- VBMFX holds approximately one third of its assets in mortgage-backed securities. And we all know how dangerous those can be, right? As it turns out, Vanguard has always done an admirable job clamping down on risk. In fact, the fund gained over 5% in 2008, a year when most other funds owning MBS tanked. Still, better safe than sorry.
- VBMFX ‘s average duration of 4.4 years is quite simply too long for my tastes. Average duration is a measure of the interest rate sensitivity of a bond fund. Basically, an average duration of 4.4 years means that for every 1% rise in interest rates, you can expect the fund to lose 4.4%. And at their current levels, there’s really nowhere for rates to go but up.
The Two-Fund Fixed Income Portfolio
Because of the above reasons and more, I recommend the David Swensen method of investing your fixed income assets as described in his book Unconventional Success: A Fundamental Approach to Personal Investment
Why two funds instead of just one? Diversification! As it turns out, inflation-protected securities (or TIPS) are excellent diversifiers. According to assetcorrelations.com, these two funds have an average correlation coefficient of around 0.65 and 0.70 over the past decade. Investors often go to great lengths to gain small incremental diversification benefits with their equity allocations, so why not do the same with their fixed income portfolios? Correlations in the 0.60-0.70 range are likely to yield modest diversification benefits going forward, and the allocation to TIPS doubles an excellent inflation hedge. In my opinion, both TIPS and nominal bonds belong in every portfolio.
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I love it, and got it initially from Larry Swedroe and, as you pointed out, David Swenson. You can even improve things a bit more by altering the division of any new contributions between the two based on a couple current data points – I forget them at the moment. But essentially by looking at interest rates and yield curves you can add some value with your decision between the two each time you contribute, without engaging in a timing gamble. Perhaps Swenson covered this too?
I just split mine 50/50 for now. If I decide to leave the Vanguard family I would like to add a third component of top-quality, currency-hedged, foreign government bonds. That would replace part of the domestic interest rate risk with foreign interest rate risk, which are uncorrelated enough to make the total fixed-income portfolio appear even more stable. It also hedges the credit risk which, while minimal with the US Treasury, is non-zero.