Bill Bernstein: Make Peace With T-Bills

April 02, 2013

In a world of unusually low interest rates, the greatest danger is to reach for yield, Bill Bernstein says.


Bill Bernstein, the former neurologist, and now the author of several books about passive investing, gets that investors looking for yield have a problem these days. Who wants to be heading into retirement at a time when the real return on risk-free Treasurys is literally negative? Well, no one.

But Bernstein, whose recent book “The Ages of the Investor” addresses the challenges of getting the final phase of an investment life right, is adamant that looking to longer-dated debt or taking on bigger risks in places like the junk market is really an accident waiting to happen for people who want nothing more than to quietly clip coupons.

So grin and bear it, Bernstein told Managing Editor Olly Ludwig, because this too shall pass, and the last thing any senior or investor with limited appetite for risk wants is to be holding something like emerging market credits when the inevitable reversion to the historical mean starts taking shape. You often talk about blood in the streets, and that’s all about expected returns, right?

Bernstein: Yes. Now, it’s not outrageous to say the expected returns in fixed income are a little compromised these days, is it?

Bernstein: I would go a step further. I would say the expected return of the average balanced portfolio with a prudent investment policy—half stocks, half bonds—is as low as it’s ever been. It’s pretty darn close to zero in a real sense, because you take a -1 percent return for safe bonds and you combine that with a 3 percent return for stocks, you get a return of 1 inflation-adjusted percent. Even at 10 years, the expected return is still a negative number, and with a 10-year T-note, you’re taking real risk. I want to take my risk with stocks, not bonds. Does this mean the orthodoxy of the previous generation that said you should gravitate increasingly to fixed income late in your life might be—if not turned on its head—tweaked in a significant way?

Bernstein: My philosophy about that, which I put in the book is: Get over it; you don’t have a choice. Get over what, exactly?

Bernstein: Get over the low expected returns of fixed-income instruments, because you don’t have a choice. If you’ve saved up enough assets to retire on, you still want to put it into relatively riskless assets—T-bills, CDs, things like that that have relatively short maturities. If things mean-revert, you’ll be fine; you’ll be back up to the normal historical yields. The yields we’re looking at are obviously artificially low, and will inevitably reverse.

It’s very unfortunate that bonds have a negative expected real return right now. Unfortunately, the best thing to do is just to grin and bear it, because the alternatives—mainly extending durations or buying lower credit quality—are probably going to bite you at some point in the not-too-distant future. Burton Malkiel says--and he's certainly not saying to bet the farm--but he’s saying, why not integrate some pretty dependable large-cap stocks with dividend streams that have proven the test of time: the ATTs of the world. And there are certainly diversified equity vehicles organized around that principle. Do you buy it, or do you think that’s an accident waiting to happen?

Bernstein: Well of course it is. It’s a question of return and risks. The real return of ATT is fairly reasonable: You’ve got a nice healthy dividend; you may even have some capital appreciation, although that’s dubious. But you have to be willing—even with an ATT—to watch 30 or 40 percent of your capital disappear temporarily, and perhaps permanently. You’re talking about a market correction taking your beloved dividend stock down with it?

Bernstein: Right. But the dividend probably won’t decrease that much. What happened top to bottom from ’07 to ’09 was the S&P fell in price by more than 50 percent, but the dividend yield only went down by 23 percent, and in the Great Depression, prices fell by 90 percent and dividends only fell by half. The point is, who is doing this in your example? The kind of person who is doing this is someone who is used to safe assets, and who isn't prepared for the vicissitudes of the stock market. So grin and bear it, is what you’re counseling?

Bernstein: Yes; the person who’s used to T-bills and CDs is not going to be prepared for what happens to junk bonds and high-dividend-yielding stocks. In one of our early conversations about this topic of fixed-income investing, you talked about Pascal’s Wager—that you’re better off parking your assets in very short, safe maturities even if the return is disappointing, even negative, as you were saying a moment ago, rather than going out on the curve looking for a little bit of extra yield because the potential for “unpleasantness” is all too real.

Bernstein: Yes, and one of these years I’ll be right about that! That’s the catch, right? But you’re entirely comfortable with being tarred and feathered on that basis, because in your mind, there is no choice, right?

Bernstein: That’s right. There is no choice. And I still own a lot of risky assets, which have done really well the past three years. So it’s not like I’m crying in my beer. Would I have been better off owning lots of 30-year bonds? Sure I would have. But that’s not where I choose to take my risk.

To me, there are risky assets and there are riskless assets. To me, a junk bond or an emerging markets bonds or any T-note longer than 10 years is a very risky asset. So looking at the world of investment management at this time of low expected returns in fixed income, is the challenge not to blow it in terms of reaching for yield? Do you see things in such stark terms?

Bernstein: Yes, I do.



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