# What Bonds Protect You Best In A Market Downturn?



## 0okm9ijn (Jun 2, 2012)

One reason to invest in bonds is to protect against a stock market downturn, which happened in 2008. Which bonds protect you most during a market downturn? I'm using iShares 2008 bond ETF returns as surrogates for Canadian bond categories . 

Government Bond Index 8.7% 
Short Term Bond Index 8.03% 
Bond index 6.13% 
Long Term Bond Index 2.16% 
Real Return Bond Index -0.03% 
Corporate Bond Index -0.59% 

I'm trying to find information on how provincial bonds and crown corp bonds did in 2008. Does anyone know where I can get such information?

I'm using Vanguard mutual fund 2008 returns as proxies.

Their GNMA fund is a proxy for crown corp bonds. In 2008, its return was 7.22%. The subprime mortgage problem wasn't a problem for GNMA.

I'm using their tax exempt funds (municipal bonds) as proxies for provincial bonds. The returns of their short term tax exempt fund, intermediate term tax exempt fund and long term tax exempt fund were 3.74%, -0.14% and -4.87%. Those would be highly diversified portfolios. Vanguard does have state specific tax exempt funds, and there were 7 of those in 2008. Their returns varies from -6.87% to -1.27%. The state specific tax exempt funds returns might be more relevant to investors purchasing individual provincial bonds.


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## mordko (Jan 23, 2016)

I don't know, but one has to be careful of focusing on 2008 too much. For example, Governments used taxes to buy certain types of bonds. Are they going to do it during future crashes?


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## 0okm9ijn (Jun 2, 2012)

Actually, I would be interested in federal bond vs. provincial bond vs. crown corporate bond returns.


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## My Own Advisor (Sep 24, 2012)

For simplicity you can consider a short-term bond ETF. With interest rates as low as they are, I wouldn't look at bonds for big returns. They will however provide you with some emotional benefits to stomach equity downturns.


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## james4beach (Nov 15, 2012)

I advised on bond portfolios in the lead-up to the financial crisis, and through the crisis, so I have some experience with this.

The most resilient bonds during a rough market are the ones with the highest credit quality - AAA. This means *federal government bonds*, but not provincials and definitely not corporates. Another factor is the maturity/duration of the bond. The longer the maturity, the more volatility in a bond price... both in good times and bad.

The ideal answer for "safety" is therefore federal government bonds with shorter maturities, like under 5 years. During 2007 and 2008 when my clients were concerned about market turmoil, I advised them to load up on Government of Canada and US Treasury bonds with 2 to 5 years maturity.

My advice today would be the same, if someone wants to insulate themselves against a market crisis. You can either buy the bonds directly through your discount brokerage, or use one of these bond ETFs.

*CLF* : 61% AAA paper and 3 year avg maturity (has securities lending)
*VSB* : 57% AAA paper and 3 year avg maturity (NO securities lending)
*XSB* : 52% AAA paper and 3 year avg maturity (has securities lending)

Of these, I'd probably use VSB myself because Vanguard doesn't do securities lending and VSB has much better daily volume and liquidity than CLF.

You can use stockcharts to look at performance during 2008. Note that VSB didn't exist back then, and CLF only appeared mid 2008.
http://stockcharts.com/h-sc/ui?s=XSB.TO&p=D&st=2008-01-01&en=2009-01-01&id=p50305718156


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## james4beach (Nov 15, 2012)

And here are some charts for the ones I mentioned, from June 2008 - June 2009

CLF chart
VSB / XSB chart (assume they'd act about the same)

And here is an example of something that _was not resilient_, this is a generic bond fund that holds a mix of government and corporates. It's normally considered to be safe enough, but notice how ... due to their corporate exposure and lower-than-government-grade, their prices fell as much as -10%

AGG generic bond fund chart


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## lonewolf :) (Sep 13, 2016)

Here is the problem rating agencies are paid by governments & Corporations wanting to get their bonds rated. Those rating the bonds are also subject to herding when the masses view government bonds as the safest it bends the thinking of the rating agencies. Governments keep going deeper & deeper into debt year after year & have no intention of ever repaying. Its a game of hot potato throughout history governments default on their bonds it is just a matter of when. Corporate bonds are backed by assets. I dont buy bonds instead use GICs Manitoba online credit unions no conflict of interest as member owned.


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## james4beach (Nov 15, 2012)

The only way the government of Canada or US will ever default on a bond, is if their government decides to default. Because they can print money, there is not any actual reason for them to ever default. The last time the US got close to default was when the Republicans threatened to refuse to continue discussions on spending approvals.

For example Trump -- being an extremely unpredictable man -- could decree that the USA shall default on its treasury bonds. It's within his ability.

However, a properly functioning government would never default on its bonds. With the USA, I agree it's a risk because of Trump. Back under Obama, default was a risk because the Republicans threatened to force it, _not because the US was unable to pay its bills_. The ratings agencies cut America's credit rating as a result.

I prefer Government of Canada bonds over US Treasuries for this reason. Canada has a properly functioning and predictable government; US does not.


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## My Own Advisor (Sep 24, 2012)

Big fan of VSB or XSB for a bond ETF. Keep it simple. Thoughts James?

BTW - Trump is a nightmare....the mess is only beginning...horrific.


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## lonewolf :) (Sep 13, 2016)

james4beach said:


> The only way the government of Canada or US will ever default on a bond, is if their government decides to default. Because they can print money, there is not any actual reason for them to ever default.


 From my understanding it is against the law for the government to just print money it has to be borrowed. Make currencies worthless or default ?


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## gibor365 (Apr 1, 2011)

> The most resilient bonds during a rough market are the ones with the highest credit quality - AAA. This means federal government bonds, but not provincials and definitely not corporates.


 Not sure that some corporate bonds are worse than federal ones...
For example USA has AA+ rating, and some companies like JNJ or MSFT have AAA.
Even though Canada has AAA rating, I'm rather bearish on Canada.


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## 0okm9ijn (Jun 2, 2012)

Thanks for the feedback. 

There are two issues during a market downturn.

One is credit/default risk. Alberta and Newfoundland both defaulted on debt in the 1930s. Provincial bonds have greater credit/default risk. All governments can tax. But only the federal government can print money. Less commonly mentioned is that the federal government can make it expensive for you to leave the country. A provincial government can't do that, if you decide to leave a province in financial trouble. So the federal government's ability to enforce taxation is greater than that of provincial governments. 

The second is liquidity. Does anyone know how federal crown corp bonds did in 2008? For a bond neophyte such as myself, federal crown corp bonds look attractive. They have the same credit/default risk as government of Canada bonds, but with slightly higher return. I assume that the price you pay for that increased return is decreased liquidity.

I never thought about the impact of security lending during a crisis, and it's an excellent point. Any type of lending involves risk, and the risk of security lending may very well show up, when you least want it to.


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## james4beach (Nov 15, 2012)

My Own Advisor said:


> Big fan of VSB or XSB for a bond ETF. Keep it simple. Thoughts James?


I agree, VSB or XSB are great options for this defensive purpose.

VSB might be better in theory, but XSB's track record is incredibly good too. Both are great options.



> BTW - Trump is a nightmare....the mess is only beginning...horrific.


He is a nightmare.


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## james4beach (Nov 15, 2012)

Agency bonds like CMHC are less liquid than actual federal government bonds. However I did not trade CMHC bonds during the crisis so I can't comment on their liquidity under market stress.

Government of Canada bonds were perfectly liquid during the crisis.

By securities lending, I'm referring to the policies of the ETF company. iShares and BMO engage in securities lending, but Vanguard does not.


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## 0okm9ijn (Jun 2, 2012)

About Canadian agency bonds during 2008, I can't find information. I can find information about Vanguard's GNMA fund during that time. This was during the subprime mortgage crisis, so an argument can be made that one would expect volatility. But GNMA bonds have always had the explicit guarantee of the US government. The Vanguard fund has about $US26 billion in assets. I can't find a number on the size of the GNMA bond market. Nevertheless, the size of the Vanguard fund would suggest that it's not a small market. 

stockcharts.com/h-sc/ui?s=VFIIX&p=D&st=2008-01-01&en=2009-01-01&id=p01029223952 You have to put http etc in front of the link. I can't post links due to my number of posts. 

The above chart gives the price history of Vanguard's GNMA fund during 2008. It's very approximately three times as volatile as XSB. Part of that is due to the longer duration of the GNMA bonds; the present duration on the Vanguard fund is 5.0 years. Neverthless, Vanguard's GNMA fund showed some volatility in 2008.

Vanguard has an intermediate Treasury fund, with a present duration of 5.3 years. So a comparison of that fund (VFITX) to the GNMA fund is a more apples to apples comparison. Similar duration and similar credit quality. I assume that the difference between the two would be due to liquidity mostly, although the subprime mortgage crisis complicates that. And there is the prepayment risk with GNMA bonds. 

stockcharts.com/h-sc/ui?s=VFITX&p=D&st=2006-01-02&en=2009-01-01&id=p91705897914 Put http:// in front of it. 

The intermediate Treasury fund had less volatility than XSB during 2008.

Based on the above, a reasonable assumption is that Canadian federal agency bonds during 2008 had considerably more volatility than government of Canada bonds. Also remember, that liquidity on Canadian federal agency bonds would most likely be quite a bit less than GNMA bonds. My guess is that the GNMA market is considerably higher than its Canadian counterparts. 

So I'm not sure if Canadian federal agency bonds are a good idea, if you want liquidity during a financial crisis.


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## james4beach (Nov 15, 2012)

Thanks 0okm9ijn those are good observations.

It would make sense that agency bonds are less solid than pure federal bonds. For example if there was a Canadian real estate crisis, it would make sense that CMHC bonds would get depressed. They already have higher yields than federal bonds.

But there are some differences between US and Canada. For example, Fannie Mae bonds. These were "agency bonds" in the US, however the bonds were never guaranteed by the US government. This was a common misconception at the time.

However, CMHC bonds are guaranteed by the federal government. I can't speak for other agency bonds though.


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## agent99 (Sep 11, 2013)

james4beach said:


> I advised on bond portfolios in the lead-up to the financial crisis, and through the crisis, so I have some experience with this.
> 
> The most resilient bonds during a rough market are the ones with the highest credit quality - AAA. This means *federal government bonds*, but not provincials and definitely not corporates.


I only advise my wife and myself. We held corporate bonds through the financial crisis and even bought more when some matured. All had considerably higher yield than any type of government bond. None of them defaulted and interest continued to be paid as expected. I would do the same again. I personally avoid all bond funds, but I would not dream of advising anyone else about anything investment related!


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## james4beach (Nov 15, 2012)

agent99 said:


> We held corporate bonds through the financial crisis and even bought more when some matured. All had considerably higher yield than any type of government bond.


Corporate bonds should yield more than government bonds. Higher risk, higher reward.

Did you hold them directly, or was this through a bond fund?


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## agent99 (Sep 11, 2013)

james4beach said:


> Corporate bonds should yield more than government bonds. Higher risk, higher reward.
> 
> Did you hold them directly, or was this through a bond fund?





> _I personally avoid all bond funds_


 Buy individual bonds. Corporate bonds do have equity-like risk. But not as volatile as the stock in a downturn. Not many major companies fail or default on their debt. But is does happen. I try to own a diversified bond portfolio from perhaps 20-30 different corporations (haven't counted them lately!). This report is old, but does give a measure of default likelihood vs credit rating. http://www.investmentreview.com/files/2009/12/default_rates1.pdf


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## 0okm9ijn (Jun 2, 2012)

Although I don't think bond funds are a bad way to invest, they turn bonds into sluggish stocks. A key difference between bonds and stocks is that the timing and quantity of cash flows from a bond are certain, assuming no credit risk. With a bond fund, that certainty is gone. 

About corporate bonds, good for you in having 20-30 corporate bonds. But owning individual corporate bonds is similar to owning individual stocks. When it comes to security selection, I can't pick stocks and I can't pick corporate bonds. Also, when you invest in corporate bonds, diversification is important. It makes sense to own 20+ corporate bonds. But buying bonds isn't like buying stocks. The cost of buying bonds increases as you buy smaller amounts. So you have to have a good sized portfolio to own individual corporate bonds.

As for government bonds and GICs, I feel much more comfortable with my ability to select securities. A government of Canada bond or a federal agency bond or a GIC has the backing of the federal government. There are differences in return between them, and liquidity plays an important role in those differences. But if I'm confident that I will buy and hold a bond or GIC, I can get a liquidity premium. If liquidity is important to me, I can buy Canada bonds. If the bond market seizes, Canada bonds are the least likely to be effected. If one is concerned about Canada bonds seizing, an alternative would be to store 6 months of food. 

And with Canada bonds or federal agency bonds or GICs, diversification is much less important. It is possible that the government of Canada might default on its debt. But if it did, then the situation would likely be so dire that diversification wouldn't make a difference. With Canada bonds or federal agency bonds or GICs, I feel comfortable having one bond/GIC as one rung of a ladder or one bond/GIC matching a future cash flow liability. With less need for diversification, my portfolio size can be smaller. And because my portfolio can be more concentrated, my transaction costs may be lower.


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## james4beach (Nov 15, 2012)

I'm not a fan of bond funds/ETFs either, but if I wanted to invest in corporate bonds, I'd buy the ETF. Otherwise it's very challenging to build a sufficiently diversified corporate portfolio. You really have to manage it very carefully, and liquidity in corporates isn't great.

0okm9ijn - I do it the way you suggest. I buy individual Government of Canada bonds, and of course GICs, and a few agency bonds too (I hold some CMHC). Canada is not going to default. The CDIC is not going to fail to cover GICs. With discount brokerages today, you can see a great selection of GICs, and you can trade Canada bonds at low fees... they are incredibly liquid.

P.S. if you're interested, I hold a govt bond + GIC portfolio and am tracking it against VAB
http://canadianmoneyforum.com/showthread.php/103945-Running-my-own-bond-fund-comparing-to-VAB


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## 0okm9ijn (Jun 2, 2012)

Here are some thoughts on fixed income for me. Please criticize.

I'm primarily a taxable investor, and my marginal tax rate isn't low. After taking into acccount taxes and expenses, my expected real return on fixed income is negative. For me, fixed income is a risk management tool. I use it as a source of liquidity, to match assets to liabilities in the next 5 years, and to have a bond ladder that will bridge me over cyclical bear markets.

Other advantages of owning your own bonds/GICs is if your portfolio is large enough, the cost may be lower than a fund. You can tailor the portfolio to your needs. You can select securities in a more tax sensitive manner. If I'm confident that I don't need liquidity, GICs are an option. If there is a small chance I might need liquidity, federal government agency bonds or cashable GICS are an option. 

About a DIY corporate bond portfolio, it's not just a matter of skill (which I don't have), but also time. Do I want to spend the time analyzing 20-30 different bonds? And with a DIY corporate bond portfolio, you have to overcome the extra transactions costs versus government bonds or GICs. If defaults are an issue in your 30 bond portfolio, the increased yield that one wants may end up being a decreased return relative to government bonds/GICs.

If I were to invest in corporate bonds, I'd use a fund.

I'm not that interested in corporate bonds, but I've heard good arguments made for them, especially short term corporate bonds.

Historically in the USA, the credit premium hasn't been well rewarded. Unfortunately, I haven't seen any Canadian data. And the credit premium tends to correlate with the equity premium. With corporate bonds, they tend to do worse when stocks do worse, which to some extent defeats the purpose of diversification. Of course, if you buy and hold corporate bonds and are confident that they won't default, this correlation is less important.

I prefer to take my risk on the equity side, as the equity risk premium has been better rewarded than the credit premium. This is especially true for a taxable investor in a higher marginal tax bracket.

I keep duration short. For me, bonds are a risk management tool. Bonds are less risky than stocks, but that changes as the holding period increases. In my tax bracket, bonds have similar risks to stocks for a 4-10 year holding period. After 10 years, bonds have more risk than stocks. Short duration does mean more reinvestment risk, and it also means lower return, as you're not going farther out in the yield curve. But historically in the USA, most of the interest risk premium has come in the first few years. From what I've seen, possibly the greatest risk to fixed nominal income investments is inflation. Stocks can recover from inflation, but it's a different story for nominal bonds. By keeping duration short, I decrease inflation risk. I also decrease price or market risk by going short. If one is going to buy and hold, price risk is not a risk. But if you have to sell, it is. 

Going short does increase reinvestment risk. But a ladder decreases reinvestment risk: you buy a new bond each year, so you diversify your reinvestment risk across time. You're also engaging in dollar cost averaging. You buy more when cheaper, and less when more expensive. This will improve your return in the long run.


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## My Own Advisor (Sep 24, 2012)

"Here are some thoughts on fixed income for me. Please criticize."

Here are some perspectives...for FWIW:

1. Bonds in a taxable account are not ideal. You are taxed at the highest possible rate on interest income. This means each dollar of interest earned will be taxed at your marginal income rate. Therefore, interest income is the least favourable type of investment income - in a taxable account. I prefer capital gains and dividends (from CDN dividend stocks) in a taxable account.

2. In this climate, bonds are earning next to nothing - when compared to equities. Will it always be that way? I don't know! As interest rates rise bond prices will fall. If you don't need liquidity and want fixed income - GICs are good. Otherwise, I believe keeping cash is a good hedge against a bad equity market.

3. I wouldn't want to analyze lots of bonds either just like I wouldn't want to analyze 20-30 stocks. This is why a simple, short-term duration, bond ETF makes great sense.

4. I also prefer to take my investment risks mostly with equities.

Happy investing!


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## agent99 (Sep 11, 2013)

1. Interest on Bonds in a registered account will also be taxed at the highest rate, once withdrawn. But at least a deferral of taxes. 
2. Seldom makes sense to trade bonds. If held to maturity, liquidity and bond prices are no concern.
3. Bonds and debentures are much easier to analyze than stocks. If you can't read a prospectus you shouldn't be in either. Even ETFs need to analyzed - need to understand what you are buying, regardless.
4. I buy corporate bonds and convertibles with 3-6 yr maturity. Mostly from companies that I feel will not default in that time frame. I read the prospectuses and read the company financial reports first. Much less risk with these than with equity of same companies.
5. Own more equity than fixed income. In 2008 recession, equity dropped about 50%, but fixed income hardly at all. Nice downside cushion.
6. Being in retirement, we like to draw 3.5-4%. I try not to invest in anything that yields less than that. Which means that risk at times increases a little, but not much on the overall portfolio.

Bear in mind, that we are well into retirement and that I am not suggesting anyone should do as I do!


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## OnlyMyOpinion (Sep 1, 2013)

^+1 Good points Agent99.

We use a ladder of corporate strips (BBB or greater) held until maturity to provide annual retirement income (although disbursements are also offset by div income). Most recently bought Bell with 8yrs left paying 3.6%. Held non-reg, so we do have to report accrued int each year.
Certainly can help reduce the equity nausea that days like today might otherwise cause. :calm:


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## 0okm9ijn (Jun 2, 2012)

Bonds in a tax advantaged account certainly help with a high tax rate. And strips in a tax advantaged account also work well. However, I don't necessarily put bonds in my tax advantaged space, which is comparatively limited. I want to maximize the tax savings in my tax advantaged accounts. Taxation on bonds is higher than cap gains or Canadian dividends. But when bond returns are so low, I may save more tax by having stocks in my tax advantaged accounts. Also, in an open account, I have more flexibility, when it comes to buying fixed income products. For example, assume one's portfolio is at TDDI, and you want to buy a GIC from someone other than TD. It would be easier to do so with nontax advantaged money, as opposed to money in an RRSP/TFSA.


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## james4beach (Nov 15, 2012)

I agree with the view that risk can be taken on with stocks, while bonds provide safety and risk management. For the same reason, I don't own any corporates (other than short term corps in BSV but only as a 401k convenience). My bond investments are nearly all govt, whereas I use stocks for high risk/reward. Then I am clear on which allocation accomplishes which goal.



> Bonds are less risky than stocks, but that changes as the holding period increases. In my tax bracket, bonds have similar risks to stocks for a 4-10 year holding period. After 10 years, bonds have more risk than stocks


Can you explain a bit about your logic on this point? Maximum drawdown on stocks is very different than bonds. Stocks can fall 50% to 60% and can stay depressed for 10-20 years. A portfolio of bonds with 10 year avg maturity (like VAB) can fall, at most, about 15%. Even during the worst bond carnage of the 1970s/1980s, bonds did not decline more than 15%, and then only as a *brief drop* (until the next bonds in the portfolios matured and rolled over at juicier higher interest rates).

And even at the worst of that 1970s bond carnage, the bond portfolio (10yr treasuries) still posted a positive return over a 10 year time span. Compare that to stocks, which can drop tens of percent, and stay down for very long periods.

So I'm not sure how you arrive at the answer that bonds have similar risk to stocks, or greater risk:

(A) your stocks can fall 50% and stay down for as much as 10-20 years
(B) your bonds (10yr treasuries) can only fall 15%, briefly, maybe for 3-4 years

_As an aside: notice how everyone is fearful of (B) today, though the risk pales in comparison to the wealth destruction risk of (A)_

Taxation and inflation don't change the outcome that stocks have greater loss potential than bonds. Stocks have also been known to show negative real returns during periods of inflation. Take a look at S&P 500 index real returns back over a century.


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## james4beach (Nov 15, 2012)

P.S. I think ZDB is a reasonably good choice for bonds in a taxable account, because it minimizes the highly taxed interest income. Personally I hold my bonds individually, and specifically buy low coupon bonds (the same strategy ZDB uses). If you are doing your own bond portfolio, make sure that you roll along the yield curve by selling bonds that are 1-2 years from maturity, and reinvest them. This is part of the magic that lets bond funds post excellent results ... the key is to maintain a constant avg maturity, and roll over bonds once their YTM drops to nil.

The short term bond ETFs like XSB and XSH are very tax inefficient in non-registered. For this reason, I use government bonds with low coupons (or ZDB) and for shorter term exposure, I use GICs which are relatively efficient.


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## 0okm9ijn (Jun 2, 2012)

About discount bonds, there are tax advantages. Also, less call risk. Also, if a bond defaults and you own a premium bond, you won't get more than par back, from what I understand.

http://seekingalpha.com/article/2286703-why-we-love-premium-bonds-and-you-should-too?v=1403732088

Larry Swedroe, in the above article, makes a case for premium bonds in a tax advantaged account. Less price risk. Less demand for premium bonds, than discount bonds, which results in better pricing. And he mentions tax advantages for premium bonds, although I'm not sure if that's relevant to Canadians.


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## hboy54 (Sep 16, 2016)

james4beach said:


> Can you explain a bit about your logic on this point? Maximum drawdown on stocks is very different than bonds. Stocks can fall 50% to 60% and can stay depressed for 10-20 years.


I think the general logic is sound, but maybe not necessarily 10 years.

Consider a bond returning 3% PA for say 20 years. A dollar here will grow to $1.806 in 20 years.

Consider the stock market using a historical long term average return of 8%. 20 years here grows to $4.66. Now have a 50% crash -> $2.33. $2.33 > $1.806. After tax, we are in even better shape.

You call scenario 2 bad because there was a 50% decline at the very end. I call scenario 2 good because you still have more money than the alternative path over the whole 20 years. To each his own.

Given that stocks have a greater return than bonds historically, and one is willing to assume this to be the case in the future, there will always be some time as time -> infinity that stocks will become "less risky" because the final resulting pool of money will be greater.

You of course will likely be unwilling to make the assumption that stocks will continue to have a higher average annual return than bonds, and this is fair enough. You will also likely assume that bonds are extremely low risk and that there is no chance of anything ever going wrong. This is not fair. Germany's currency was destroyed in the 30s from inflation. Zimbabwe's currency was destroyed whenever it was 80s or 90s. Argentina I believe has had its currency destroyed 2 or 3 times the last century. Argentina was a happening place about a century ago, not unlike Canada's position in the world now.

You enjoy imagining the worst case scenario and working with it as the highest probability scenario. I look at life through the expected value lens. I go for it with the understanding that I have a small likelyhood of extreme failure, but extremely good chances of doing just fine. 

Certainly at my age, the chances of a good economic outcome 20 years into the future given the way I do my investing are much better than my probability of still being alive. Really, life is full of risk, what more can I reasonably hope for? Do I really want to plan for a 1% chance of running out of money 20 years out on a scenario when I only have a 70% (feel free to put in the correct conditional probability of a 54 YO surviving another 20 years here) chance of survival? This is something you would probably see as a sensible goal, but I think is just silliness.

hboy54


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## olivaw (Nov 21, 2010)

Long term risk/return on stocks is great during the accumulation phase but it can be a disaster during the drawdown phase. 

Moneygal used to talk about sequence of return risk. Declines early on may never be recovered because retirees sell holdings to cover living expenses. ( IIRC, she recommended annuities as part of a healthy portfolio for those who do not have a pension. She co-authored an excellent book called _Pentionize Your Nestegg_)


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## 0okm9ijn (Jun 2, 2012)

james4beach said:


> Can you explain a bit about your logic on this point? Maximum drawdown on stocks is very different than bonds. Stocks can fall 50% to 60% and can stay depressed for 10-20 years. A portfolio of bonds with 10 year avg maturity (like VAB) can fall, at most, about 15%. Even during the worst bond carnage of the 1970s/1980s, bonds did not decline more than 15%, and then only as a *brief drop* (until the next bonds in the portfolios matured and rolled over at juicier higher interest rates).
> 
> And even at the worst of that 1970s bond carnage, the bond portfolio (10yr treasuries) still posted a positive return over a 10 year time span. Compare that to stocks, which can drop tens of percent, and stay down for very long periods.
> 
> ...


This is from p.95 of "Stocks for the Long Run". This shows highest and lowest real returns on stocks, bonds and bills over 1, 2 5,10, 20 and 30 years holding periods in the USA between 1802-2012.

Worst 1 year return for stocks is -38.6%, for bonds -21.9%. 2 years -31.7%, -15.9%, 5 years -11.9% -10.1%, 10 years -4.1% -5.4%, 20 years 1.0% -3.1% 30 years 2.8% -2.0%

By 5 years, the worst real returns are similar for stocks and bonds. 

http://mebfaber.com/2015/01/30/everything-old-is-new-again/

worst real drawdown between 1973-2013 in the USA. -44.75% for bonds -54.12% for stocks

http://www.financialwisdomforum.org...ds+were+already+in+a+massive+drawdown#p544770

About duration of bond drawdowns, see the above link. In real terms, bond bear markets can last for decades.

Assume you're in a top tax bracket in Canada. Bonds are taxed at 50%. Total return from stocks will be taxed around 25-30%, and much of that can be deferred.


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## 0okm9ijn (Jun 2, 2012)

LInk on rolling down the yield curve. I'll have to look into this further.

https://www.kitces.com/blog/how-bon...ve-help-defend-against-rising-interest-rates/


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## 0okm9ijn (Jun 2, 2012)

james4beach said:


> Taxation and inflation don't change the outcome that stocks have greater loss potential than bonds.[/URL]


https://www.ctf.ca/ctfweb/Documents/PDF/2004ctj/04ctj4-mawani.pdf

"This study computes the real (after-inflation) after-tax returns (RATs) on one-year,
three-year, and five-year GICs during the period 1974-2003. In our analysis, we assume
that on maturity these GICs were rolled over into new GICs with an identical term and an
interest rate based on the (historical) average market rate quoted by the major banks
and trust companies in the year of the rollover. We show that annualized RATs have
been negative for Ontario investors in the top marginal personal tax bracket for most of
the study period. For example, any investor whose marginal personal tax rate exceeded
35.5 percent earned, on average, a negative annual RAT from one-year GICs rolled over
continuously from 1974-2003. For three-year and five-year GICs, the breakeven tax rate
was slightly higher at 42.06 percent. Even when positive, RATs rarely exceeded 1 percent."

For some investors, fixed income has a negative expected return in a taxable account.


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## james4beach (Nov 15, 2012)

0okm9ijn - very interesting points raised, I will study those links you posted and follow up. I haven't forgotten about this, I just have some other things to attend to.


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## james4beach (Nov 15, 2012)

I wonder if we're talking about different things when we say "risk". Here's my reasoning...

Stocks, example 2007, we saw -55% max drawdown notional or about -57% real drawdown. I don't see how taxes play into this at all when you have a portfolio sitting there with no taxable selling. *So with stocks, "risk" is about -57% drawdown in real terms.*

Now the question becomes, for a bond portfolio (say the 10 year avg maturity as per XBB and VAB) what is the maximum drawdown in real terms?

For the 10 yr avg maturity bond portfolio, the maximum drawdown is -16% notional, a period of about a year around 1980. Using the highest CPI of 13% I could see the argument that bonds have a "risk" of about -29% drawdown in real terms.

I think taxes have a minimal effect on all this because both of these drawdowns are over about a year. The portfolio isn't liquidated; its value just fluctuates. In the bond portfolio, there's taxation on the coupon payments. With the large 10 pct coupons I could see a significant loss there, so let's say you pay huge tax and only get to keep 5 pct of the 10 pct coupon. The drawdown only lasted about a year so that's another -5% haircut on the performance. (Let me remind you that coupons are minimal today, so the bond tax effect in current times is far more minimal than this 1980 example)

That takes the bond performance down further and I could be convinced that *bonds have a "risk" of about -29-5 = -34% drawdown in real terms.*

I agree that the inflation and tax effects close the cap between stock & bond risk. I arrive at stocks around -57% drawdown and bonds around -34% drawdown.

I still see more safety in bonds than stocks. I took a look at the chart you linked to that showed some horrendously large bond drawdowns. They don't specify the type of bonds. The numbers are not consistent with 10 year treasuries... they have clearly used something far more volatile. My guess is that they've used 30 year treasuries. Pension funds hold 30 years, but regular investors don't: all the standard bond funds have about 10 year avg maturity. I will try to find a source on maximum drawdown in real terms for 10 year bonds, but I suspect it will be close to my estimate calculated above, which is -34%

I agree it will be worth delving a bit more into the max drawdown of bonds, in real terms, for the 1973-1983 period. Perhaps I have not calculated the real return properly and it would be good to calculate it more carefully or see a reference that clearly states what kind of bond they're using.


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## mordko (Jan 23, 2016)

Government or municipal bonds with under five year duration plus TIPS protect you the best. Long term bonds are just as risky as stocks. And right now the math does not work for any bonds unless I am missing something obvious. When people buy stuff ignoring arithmetics, it's a bubble, although the scale isn't the same as for stock bubbles.


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## james4beach (Nov 15, 2012)

I don't have the time to calculate it now, but a good source for figuring this out will be the Portfolio Visualizer:

https://www.portfoliovisualizer.com...2=Custom&portfolio3=Custom&TreasuryNotes1=100

That link will show you the return on a 10 yr treasury bond portfolio from 1978-1983. Maximum drawdown (notional) is shown to be -16%. Perhaps from this data we could calculate the max drawdown in real terms


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## james4beach (Nov 15, 2012)

mordko said:


> Long term bonds are just as risky as stocks.


I agree, but I've never endorsed long maturity bonds on the forums.


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## 0okm9ijn (Jun 2, 2012)

The point has been raised that the data I present is for long term bonds (30 year bonds?). The following is from p.95 of "Stocks for the Long Run". This shows highest and lowest real returns on stocks, bonds and bills over 1, 2 5,10, 20 and 30 years holding periods in the USA between 1802-2012.

Worst 1 year return for stocks is -38.6%, for cash -15.6%. 2 years -31.7% -15.1% , 5 years -11.9% -8.3%, 10 years -4.1% -6.1% , 20 years 1.0% -3.0% , 30 years 2.8% -1.6%

If your time horizon is 1-5 years, cash and bonds are safer than stocks. But if you have a time horizon of 5-10 years or more, stocks are safer than cash or bonds. 

http://www.pragcap.com/stock-and-bond-drawdowns-historical-perspective/

In a single year, there is no doubt that stocks have much greater drawdown risk than bonds, whether in nominal or real terms. And in a single year, taxes aren't that important. 

http://mebfaber.com/2015/03/02/chapter-1-a-history-of-stocks-bonds-and-bills/

"The U.S. and the U.K. have both seen real bond drawdowns of over 60%. While that sounds painful, in many other countries (Japan, Germany, Italy, and France), it was worse than 80%...The same principle occurs in the U.K., but bond investors had to wait even longer to get back to even – almost 50 years!"

If you are looking at multiyear drawdowns, taxes are relevant.


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## james4beach (Nov 15, 2012)

These are interesting observations and I think I see now the difference in what we were arguing: I was talking exclusively about those short term drawdowns.

I'm going to have to look more carefully at those rolling, multi year returns and especially the tax effect.

Let's not forget another aspect though, portfolio design and asset diversification. There's a reason to combine stocks and bonds, and for that matter stocks & bonds & gold ... for the low correlations between the assets, and overall smoothing effect of drawdown.


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## 0okm9ijn (Jun 2, 2012)

james4beach said:


> There's a reason to combine stocks and bonds, and for that matter stocks & bonds & gold ... for the low correlations between the assets, and overall smoothing effect of drawdown.


For me, an investment is a product that has an expected positive return after inflation, expenses and taxes. 

Gold has an expected pretax return of zero. For me, bonds have an expected negative posttax return, and their expected pretax return isn't much better. The present yield of the government of Canada 10 year bond is 1.76%. The most recent Canadian inflation rate that I can get is from the website below, which states Canada had an inflation rate of 1.5% in December 2016.

http://www.tradingeconomics.com/canada/inflation-cpi

Gold and bonds are not investments; they're risk management tools. There are many, who would disagree with that conclusion. But if you agree with that conclusion, they should be kept to the minimum required.


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