The Role of Bonds
I need to start with a confession.
For years, I have touted the importance of a proper asset allocation of both stocks and bonds in a balanced investment portfolio.
But I don’t own any bonds. None. Zero. Zilch.
It’s not that I think bonds are bad. I truly believe they have a time and place in every investment portfolio, but I haven’t ever been able to make that case for myself.
I’ve heard plenty of appealing arguments for holding bonds and they are all quite valid. In fact, I’m going to plead that same case as you read on.
However, none of these arguments has ever been convincing enough to compel me to move out of my near-100% stock allocation and to buy bonds in some relatively significant portion.
I’ll explain myself as you read on, but first, let’s make the case for buying bonds, shall we?
Case 1: Diversification
This first point has its roots in an idea that will become a bit of a theme as this post unfolds:
Bonds are not stocks.
That singular concept is the most persuasive argument I can make for bonds.
And it’s not that stocks are bad. At least, not most of the time.
The truth is stocks are clearly a superior driver for portfolio growth compared to other asset types, but the stock market also suffers more when outside forces trigger a sudden desire for liquidity or security.
Put more simply, stocks experience significant volatility.
I wouldn’t go so far as to say that bonds are immune to the same forces that might negatively impact stocks, but bonds are much better suited to weather economic storms.
More importantly, the yields of bonds are not correlated to the rises and falls of the stock market.
You see, a bond is a debt instrument.
- When you (or the fund you own)
- buy a bond you’re handing over money (at the issue price; generally $1000 per bond)
- to some entity (a company or government)
- with the understanding that you will receive an interest payment (known as a coupon payment)
- at a given interest rate (known as the coupon rate)
- at a certain interval (known as the coupon date; usually every 6 months)
- for a certain period (known as the maturity date)
- until the bond issuer returns the money at the bond’s face value (usually the same amount you paid for the bond initially).
None of the events in this rather lengthy string of events is dependent upon economic forces like unemployment, the prevailing fed funds rate, the cost of goat tenderloin in China, or who’s elected to what office at a given time.
The primary risk consideration in a bond is the creditworthiness of the bond issuer. Basically, if the bond issuer goes belly-up, your bonds are worthless.
Beyond that, you know the returns you can expect from a bond which is why they tend to be lower than that of stocks.
The reward, however, is lower volatility, which is a welcome ballast to a volatile basket of stocks.
By diversifying your portfolio with bonds, you place a stake in an asset class for which the risk isn’t closely associated with that of stocks meaning they are unlikely to both decrease in value at the same time.
In fact, if you hold a bond until it matures, you’re virtually guaranteed to earn a return (unless the issue goes bankrupt).
Case 2: Timing
The second case I’m making for bonds isn’t drastically different from the previous one.
Bonds are not stocks, and because of that bonds do not share a similar volatility profile with stocks.
If you’ve invested in stocks for very long, then you’ve surely seen a market swoon or two before.
As recently as the end of 2021, the stock market began to take a slow but significant dip. It took almost two years for investors to see valuations recover to their 2021 highs.
Going a bit further back to 2007 to 2009 (The Great Recession) we saw the overall value of the market decline for a year and a half, reaching nearly half of its then all-time high in the Fall of 2007.
It took a few years, but prices did eventually recover. The Dow Jones was able to climb back to 2007 levels in the Spring of 2013.
Worse yet, stock indices in 2010 were level compared to more than a decade earlier at the advent of the dot com bubble. (a.k.a. “the lost decade”)
Can you imagine owning investments that didn’t grow at all for over a decade?
Ouch.
If you can, then I’d invite you to imagine another scenario with me.
Imagine yourself approaching retirement with a portfolio full of stocks just as one of these downturns occurs.
Double ouch.
This is known as sequence of returns risk and it’s important to understand.
I remember colleagues who had plans to retire leading up to 2010 but had to work several years more because of the damage done to their net worth in The Great Recession.
It was difficult to watch, but I’m sure it would have been much more difficult to navigate.
On the other hand, I also had colleagues who retired anyway. I don’t know for sure, but I’m guessing at least some portion of their living costs were covered by assets or funds that were not tied up in stocks.
You know, assets like bonds.
It’s possible that they also had enough stock that they didn’t care and just sold at rock-bottom prices anyway.
Either way, there’s no doubt diversification would have been a strong ally in such an unsettling time.
Bonds provide an opportunity for investors to move at least a portion of their assets away from market risk and secure something for short to intermediate living expenses.
In other words, if you have enough of your wealth in bonds, you can ride out challenging times in the stock market and won’t have to hope your retirement aligns with a good time in the stock market.
How much to set aside is a personal preference. I have heard of retirees holding everything from two years to 15 years or longer of living expenses in bonds or cash equivalents (these are not the same, btw).
Personally, given the history of downturns we’ve seen over time, I think five to seven years would be enough for me, but again, this is a personal preference.
Also, keep in mind that bonds are best suited for expenses that are two to five years out. For more immediate cash needs you should stick with cash equivalents like money markets or CDs.
Case 3: Lower Volatility
We’ve already made case three to some extent, albeit for different reasons.
In case 2, we illustrated how the volatility of stocks generates sequence of return risk, meaning stocks could leave you in a situation where you have to sell your stocks when they are at low values (when you should be buying).
Now, I want to make a similar case, but for those of us who have many years before we retire.
There are millions of investors in the United States and they’re all unique, meaning we all have varying levels of tolerance to risk.
We all know some people who are convinced that even the slightest downturn in stock prices is an indication of more pain to come. Maybe you are that person.
We also probably know people who can set and forget it. The daily ups and downs of the stock market are no more meaningful to them than which direction the wind blows.
Having a basket of assets in low-volatility investments like bonds can be very reassuring to those of us with a low tolerance to risk.
If you’re tempted to smash the panic button every time the stock market sees a dip, then you should absolutely hold some portion of your investments in bonds.
How much is up to you, but it should be enough to prevent you from making the impulsive decision to sell all of your stocks at the worst possible time: when they are at their lowest prices.
Panicking exposes you to the same sequence of returns risk, only if you’re not close to retirement then there’s no real need to panic because you have time to see the stock market recover.
Case 4: Strategy
There are several investing strategies that bonds provide, two of which I will discuss now.
The first is income generation.
Because bonds typically are paid on a quarterly or semi-annual basis, they produce regular, predictable income for investors.
Bonds can be more attractive than income alternatives like annuities because most annuities benefit annuity salesmen much more than the annuitant. (I’ll save that tangent for another post.)
Also, bonds can be more attractive than dividend stocks because the value of the underlying stock can be volatile and the dividend itself could change at any time.
The second strategy is capital preservation.
One of the more annoying aspects of having a significant amount of cash that you want to keep safe is that there is no perfect protection from inflation.
You are probably quite aware that if you buried $100 in the yard for ten years, then dug it up sometime in the next decade that $100 won’t buy as much then as it will today.
In other words, by simply doing nothing your money is losing value.
One nice feature of bonds is you get your money back when they mature. In the meantime, they pay interest which serves as a shield against inflation.
In the case of zero-coupon bonds, the bond is purchased at a discount which is usually the product of prevailing market interest rates for debts that extend over that particular bond’s maturity period.
The par value is higher than the issue price so you receive more than you paid for the bond when it matures. It is a slightly different setup, but the result is the same inflation protection as before.
Case #5: Forced Rebalancing
This case is somewhat behavioral, but it may also be one of the strongest to be made for bonds.
Everyone knows the mantra highlighting the best time to buy and sell stocks.
Sell high. Buy low.
It’s astonishingly simple to say, but extraordinarily difficult to practice because no one knows when the price of a given equity will be at its peak or its bottom.
Most investors have accepted the fact that market timing does more harm than good, so they don’t try.
To be clear, I agree with them. Market timing is a fool’s errand. Don’t do it.
It makes far better since to set up systematic methods for buying and selling, so we aren’t tempted to allow emotions or current events to sway our decisions.
Having a portion of your portfolio in bonds is a way to do exactly that while also ensuring that you sell high and buy low. Here’s how it works.
Let’s assume you elect to have a 70/30 allocation of stocks to bonds in your investment portfolio.
Several months pass after you set your 70/30 portfolio and you notice that your stocks have grown much faster than the bond portion of your portfolio.
We’ll assume you now have 75% stocks and 25% in bonds.
In order to get your asset allocation back to 70/30, you sell 5% of your portfolio’s value from the stocks you own and you buy bonds with those funds.
Because you sold stocks after a run up in their prices, you’ve effectively forced yourself to “sell high”.
But what happens if stocks do poorly?
Well, in that case you’d sell your bonds to buy more stocks. This is forcing you to “buy low”.
And you’re doing all of this with complete indifference to economic or market forces (or at least you should be).
This forced system of rebalancing is a great way to harvest gains while also limiting downside risk.
You’ll also feel like less of an idiot if stocks suddenly decrease in value because you will have set aside some of the earnings they generated first.
What Bonds Aren’t
Now that I’ve presented my case for bonds, I’d like to highlight some common misconceptions people have about them.
Partially because these annoy me and partially because it will set a baseline for explaining why I don’t own bonds myself.
Bonds Are Not Always “Low Risk”
There’s a decent chance I’m even guilty of suggesting this in previous posts or YouTube videos, and if that’s true, I apologize.
But not all bonds are “low risk”.
It is certainly fair to categorize treasury bonds as low-risk. In fact, it’s difficult to find lower risk when the entity that owes the debt can simply print the money to pay it off.
I’m not saying that’s what happens…well, maybe I am. Anyhow, it’s difficult to find a more secure backer than the federal government.
However, corporations and municipalities do not share the same level of security and solvency. Even the mightiest have fallen and left their claimants with worthless coupons for bonds that won’t be returning their par, much less their yield.
I would recommend buying a total bond market index fund of some sort instead of buying bonds directly. Typically, they will invest 65% or so of the assets in U.S. government debts (a lot of this is mortgage securities) and the rest in muni’s and corporate bonds.
Indexing provides a simple way to diversify while also providing the liquidity flexibility of a mutual fund or ETF.
Bonds Are Not A Growth Engine
If you’re looking for growth in your portfolio, bonds are not where you’ll find it.
Truthfully, I don’t see this misnomer very often, but there are some exceptionally conservative investors out there who tout the value of bonds.
Yes, bonds have value, but they will not produce similar long-term returns to stocks.
Bonds Are Not Defensive
I’ve often heard bonds referred to as “defensive”. I’m not sure that’s a great characterization, though I’m sure those who use such a description mean well enough.
The truth is bonds are an offensive weapon. They give you an alternative to stocks much like a screwdriver in a toolbox provides an alternative to a hammer. Each tool has its place.
Furthermore, there are many people who buy, sell, and trade bonds as a commodity much like a stock.
The value of a bond does increase and decrease over time as competing yields increase or decrease relative to that of the bond.
If you had a bond with a 4% yield in 2020 then it was worth much more than its par value at that time.
If you held the same bond until 2023 when interest rates for even long-term treasuries surpassed 4%, then it would have been worth less because similar or better returns could be had with less risk.
Avoid the temptation to think of bonds as a CD or other cash equivalent. They are more functional than that.
Why I Don’t Own Many Bonds
Finally, I get to make my own case.
As I mentioned from the outset, I do not own a single bond or bond fund.
I have the value of one full year of personal expenses in money market accounts. The rest is completely in stock mutual funds and ETFs.
Here are a few reasons why:
1) Over The Long Run, Stocks Are Not That Risky
I’m generally not alarmed by hefty dips in the stock market. I wouldn’t say that I look forward to them, but I’m hardly tempted to sell on a bad day, week, month, or even year.
My source for this steadfast confidence is the resiliency and ingenuity of the American economy.
There’s never been an economic downturn that we haven’t recovered from and the longest period of recovery for a portfolio tracking the S&P500 since The Great Depression was only 31 months. (The lost decade I referenced earlier was tracking the Dow Jones Industrial Average.)
I go into more detail about the benefits of long-term investing in this post where I ask the question, Is Investing In Stocks Gambling?
2) I Have A Pension
About 15% of Americans have access to a traditional, defined-benefit pension plan. I am one of those lucky folks.
My pension, in which I am fully vested, is backed by the Pension Benefit Guaranty Corporation and my company which is doing pretty well financially (a regulated utility).
I have a high degree of confidence that this pension will provide steady income for my wife and I in retirement. This income will offset some portion of financial need for us in retirement meaning we won’t need quite as much from our invested assets as we otherwise would.
To quantify the value of that benefit I run a quarterly present value calculation to estimate how much it would cost me to buy a similar fixed annuity based on U.S. Treasury rates for bonds with a 30-year maturity.
Currently, the value of that pension is about 20% of our portfolio’s value. I liken it to having 20% of my assets in bonds, meaning I don’t necessarily need to buy more bonds to gain fixed-income assets.
3) Bonds Have A Lower Ceiling
Third, by owning stocks long-term, I have the benefit of higher possible gains while dampening risk over time.
On the other hand, bonds place both an artificial floor and ceiling on returns, but the floor isn’t any higher than the floor for stocks over the long-run.
Let me try to explain what I mean.
Imagine that you are charting out the possible returns for both stocks and bonds over time.
Both will gradually curve upward as both asset types tend to appreciate in value.
Furthermore, you should expect the range of projections for stocks to be much broader than that of bonds because stocks are more volatile.
You would also expect that the highest returns would be achieved through the ownership of stocks.
But would you expect the lowest returns to be produced by the stocks or the bonds?
What if I told you they were almost even? Here’s a chart from portfoliocharts.com illustrating this exact point.
Note that a 100% stock portfolio is represented in red. The gold lines represent a portfolio split evenly in 20 % stocks, small cap value stocks, long-term bonds, short-term bonds, and gold. The aqua line represents the Coward’s Portfolio which is a 60/40 blend of stocks and short-term corporate bonds.
Ironically enough, these charts were generated for an article making the case to own bonds, but it only served to confirm my decision not to buy any.
The reason is the lowest performing portfolios are all bunched together at the bottom of the range, but only stocks provided the opportunity to excel, to achieve earnings far above even the best years of the blended portfolios.
In other words, history shows that stocks produce a similar level of performance on the low end but have a potential for growth that a portfolio with bonds has never achieved.
I’ll take the upside potential for little to no additional downside risk any day (except when I’m about to retire).
4) I’ll Buy Bonds One Day
The truth is I do plan to take a very large stake in bonds one day, but it will always be based on a multiple of my annual projected expenses and never a pure allocation percentage.
I will use bonds to protect me from sequence of returns risk, acting as a buffer to provide time to ride out a market downturn and still fund my lifestyle.
The rest will probably always be in an S&P500 index fund or something similar.
Like I mentioned earlier, I think five to seven years of expenses will do the trick, but I may keep more in bonds if I don’t see the point in risking it. I’ll save that decision for another day.
Furthermore, I plan to hold two years of expenses in cash or cash equivalents like CDs or money markets for short-term needs (2 years or less).
Conclusion
Bonds have a time and a place, and I agree that they should be used, but for me, right now, I’ll stick with equities.
Hopefully the information in this post was helpful for you as you develop your own strategy for bonds in your portfolio.
Feel free to shoot us a note if you have any questions and be sure to check out our YouTube channel if you’d rather absorb this through video.
