Your Bond Allocation Doesn't Matter as Much as You Think

Quick... which of the three allocations A, B, or C is 60% S&P 500 Index / 40% Barclays U.S. Aggregate Bond Index,  55% S&P 500 Index / 45% Barclays U.S. Corporate Bond Index, or 62% S&P 500 Index / 38% Barclays Treasury Bond Index going back all the way to the inception of the Barclays U.S. Aggregate Bond Index in 1976?

Tough right? How about a chart of a growth in $1 invested in each of the allocations

Still nothing? That's because you can access credit risk two main ways... through stocks or through spread, while rate exposure at the end of the day all comes back to rates on Treasury bonds. An allocation with a higher equity tilt, balanced with bonds with no credit risk (i.e. a pure Treasury allocation) provides the same exposure (and returns) over time as one with a lower tilt towards stocks with additional credit coming from spread.

So what?

While I do think there are times when there are more attractive means of gaining credit exposure through stocks, investment grade bonds, high yield bonds (a simple model I presented back in 2010 highlights how this might add value), you need to make a material reallocation to move the needle. On the other hand, a buy and hold investor can and should allocate to credit and rates in what is the most: (1) structurally efficient (i.e. minimal transaction costs), (2) cost effective (i.e. cheapest), (3) tax-efficient. 

1. Structurally efficient: stocks and treasury bonds both trade at much tighter bid/ask spreads than corporate bonds. More important, during periods of stress, treasuries are MUCH more liquid - winner: stocks and treasuries
2. Cost effective: interestingly enough, the cheapest treasury bonds ETFs are slightly higher in cost than the cheapest Aggregate Bond ETFs, but both are slightly higher than ETFs for the S&P 500; either way, we're talking bps here - a wash
3. Tax-Efficient: the more you are allocated to stocks, the more tax efficient you become as capital gains are taxed at a much lower rate than bond coupons - winner: stocks and treasuries

Takeaway... while stocks balanced with treasuries may have a slight edge in terms of implementation, at the end of the day, it really doesn't matter. If you are spending too much of your investment time trying to decide whether to slightly change your bond allocation away from treasuries to another duration sensitive area of the bond market given fears of a rate hike, please spend your time elsewhere.

Footnote: I initially listed what allocations A, B, and C were... then I remembered it doesn't matter.