Being wealthy doesn't mean having all the money in the world, just not having to worry about it.

What Is a Good Diversification Strategy for Bonds?

Question: Andrew Tobias said to “Ask Less” the money questions. OK, here’s mine. Is the following a good diversification strategy for bond holdings: 50% total bond index, 50% intermediate bond index? Many bond funds mirror the Barclays U.S. Aggregate Bond index. However, supposedly around 75 percent of the index tracks government securities or other types of government-backed bonds. Less than 25 percent is in corporate bonds. Because of this, says John C. Bogle, founder of the Vanguard Group, total bond indexes “are deeply flawed — and that’s coming from an indexer.” He recommends individual investors should keep only about one-third of their bond stake in Treasuries and government debt. So, he says to keep half their money in a total bond market fund, the other half to an intermediate corporate bond fund.

By doing so, investors would end up with an overall strategy that’s about two-thirds in corporate debt and one-third in government securities.

Answer: I’m going to give you two answers, the politically correct answer and my actual opinion.

  1. Politically Correct — To maximize the diversification of a bond portfolio, you should hold bonds of varying maturities from different borrowers repaying in different currencies, including inflation-based repayments. Not only is that in line with Bogle’s recommendation to avoid overconcentration in the bonds of the world’s biggest borrower, the U.S. government, but it also suggests that part of the bond portfolio be devoted to inflation-protected bonds and to bonds issued by foreign corporations and governments, including emerging markets. So Bogle is right, and the method he suggested is a clear improvement in diversification.
  2. Actual Opinion — Okay, I’ve done my duty for people looking at bonds in isolation, but the far bigger issue is that you should have a small enough percentage of your total wealth in bonds that the PC answer doesn’t matter. As I mentioned in Lesson 21, on the sensible use of hedges, the historically safest portfolios have had 80% or more in equities and 20% or less in hedges, and a good part of that ought to be in an inflation hedge such as gold or futures. Well, if your bond allocation is around 10%, the difference between government and investment grade corporate bonds is pretty insignificant.

Of course, I realize many people prefer a traditional allocation limited to stocks and bonds. I’ll even concede that once someone has made that decision, the popular 60-40 allocation of the typical balanced fund is close to the safest allocation for a retiree. This is more likely what Bogle had in mind, where there is a definite safety impact based on how the bonds are split between government and corporate.

But here’s the thing: 100% Treasuries has historically been the safest allocation for the portion devoted to bonds! The reason, which I discussed in Lesson 19 on panic insurance, is that the environment which causes a bear market in corporate stocks is not likely to be one in which corporate bonds are investors’ first choice for safety. When people are afraid of the equity securities of a business, they are likely to be afraid of the debt securities of that business as well. If they pile into bonds, they’re going to pile into U.S. government bonds. A bond-index fund dominated by U.S. government securities is just what the doctor ordered.

So, in the final analysis, I DON’T agree with Bogle’s recommendation, even on his own terms. As long as an investor is sane enough to invest at least half his or her portfolio in ownership of the businesses that provide the world’s goods and services and are the foundation of the globe’s long-term standard of living, the last place to look for diversification of the remainder is in the debt of those same businesses.

In fact, since Andrew Tobias is nice enough to suggest that people ask me their money questions,
the least I can do is return the favor and quote the three-word sentence in his wonderful book, The Only Investment Guide You’ll Ever Need, which begins the section entitled “Corporate Bonds”:

“Don’t buy them.”