Questions from the Reader: My Word on my Bonds

Any Questions?

Today I’m starting a new series on questions from readers. I’m super excited that I now have questions from readers! If I’m not helping you, then this blog has failed.

Let’s succeed together, starting with this juicy question about bonds.

Question

Right now I’ve got all my long-term investments in low-fee index funds – some large-cap, some mid-cap, some small-cap, some international. Should I own any bonds too? Or rather, do you own any bonds? Like, is there any reason to diversify into that asset class, or are they always just going to be either correlated with stocks (e.g. corporate bonds) or too low-risk-low-reward (e.g. US government bonds)?

Answer

Bonds are not just “low risk stocks.” While you can treat them that way and certain types of bonds behave this way, fixed income as a whole has a set of different characteristics that can be very useful for investors with specific goals and time horizons. That said, unlike the advisor, I wouldn’t recommend them across the board. In fact, I don’t have any bonds right now, and some would argue that I have negative bonds…

Let’s start by talking about the three major asset classes:

Equity (e.g. stocks) – here you are buying a portion of future cash flows that a business will generate. Since the future payout is uncertain, these can be risky investments, but this risk also translates into higher expected returns. Many types of equity are quite liquid, such that it is easy to turn your investment into cash, but this isn’t true across the board.
Cash (e.g. dollars in a bank account) – here you have an asset that does not fluctuate in value. The only risk here is a decrease in purchasing power as prices increase over time (inflation). And since cash is cash, you have perfect liquidity. High liquidity and low risk lead to low expected returns that should for the most part barely outpace inflation.
Fixed income (e.g. bonds) – here you are loaning money to an entity that promises to pay back the principal at a certain time as well as (usually) interest along the way. The promise is not a guarantee as businesses can, say, go bankrupt, but there is generally higher certainty about payout than with equity. This reduces risk and puts expected returns in between cash and equity. Bond liquidity varies a lot by issuer: U.S. government bonds are extremely liquid, but other types may not be.

So, bonds theoretically have less risk and lower prospective returns than stocks, and history bears this out, showing that bonds have lower volatility, draw down, (or pick your favorite risk factor) than stocks at the cost of a lower return.

For example, here is a comparison of a total bond market ETF with a total stock market ETF from 2007 to today. In this time period, which includes a huge financial crisis, the annual volatility of bonds was just ~3.6%, compared to ~15% for stocks. Don’t care about volatility? How about a ~4% max drawdown on bonds vs. ~51% for stocks? So, yeah, the data show that bonds are less risky.

However, stocks also returned ~8.6% per year while bonds returned just ~3.6% per year. So there is a clear tradeoff for safety. Bonds are safer.

Or are they? Isn’t a lower expected return a risk factor? Yes, if your goal is to build a retirement nest egg like the question asker, then getting a low return puts you at a higher risk of not hitting your goals. This is critically important to understand as you think about the role that bonds play in your portfolio. When you add bonds to a portfolio, you are trading one risk for another.

What’s Good (about Bonds)

Then what’s good about bonds? First off, the financial advisor was right. Bonds usually dampen volatility in a portfolio. The question asker was worried about correlation between stocks and bonds going up in times of crisis, but for the safest classes of bonds (e.g. U.S. government securities), the opposite has actually happened in the past. In a crisis, as people flee risky stocks, they have to put the money somewhere. They can keep it in cash, but many instead buy treasuries, driving a negative correlation, both in the long run and during crises.

This negative correlation will dampen volatility, and if you’re rebalancing, theoretically it could make your portfolio have higher returns as you buy low and sell high. In practice, this doesn’t work in the long run, since you are buying a bond that will have significantly lower return than the stock you are selling. History bears this out, and as I write in 2018 prospective returns are terrible. That is, if you believe that forecasting has any value.

An advisor (really a portfolio optimizer) might also tell you that a portfolio containing bonds is more “efficient” as measured by return and volatility risk (i.e. Sharpe ratio). This could be a good reason to add some bonds to your portfolio if you don’t have some. We like efficiency here, right?

But is portfolio efficiency your actual goal? If you’re like most investors saving for retirement, you’ll care a lot about returns, but I posit that volatility is not your best measure of risk. Volatility, within reason can actually be a good thing. It allows you to buy low and sell high if you’re rebalancing. Upside volatility increases returns. It’s downside volatility and drawdown that really hurt. But… if you have the temperament to stay the course through market downturns, in general, you will have better performance with a more volatile portfolio.

Within reason, of course. If you don’t feel that you can handle a 40% drop in your portfolio without bailing out, by all means add in some bonds and get to an allocation where you feel more comfortable. Being able to stick to your investment policy under adversity is more important than the return difference between stocks and bonds…

So when are bonds appropriate? When you do care about volatility. Remember that fixed income assets pay out according to an agreed upon schedule. If you need the money at a specific time and it’s important that it be there, then bonds really are a better option than stocks.

Why might this be you? Perhaps you have a short time horizon. If you need the money for something within the next 5 years (say a downpayment on a house or to pay for your child’s college education), fixed income investments are a great choice. I’d recommend staying away from a bond fund, which while convenient, doesn’t allow you to time when the money will be available. If you buy a CD or even an individual treasury from TreasuryDirect you can avoid the fees built in to bond funds while timing your payout exactly. If you hold a bond to maturity, you’ll know exactly how much money you’ll be getting when. If it’s a CD, it will even be insured against default by the government. It doesn’t get much safer than that.

If you don’t need the money right away, but you can’t handle volatility because your horizon is pretty short (say you’re 10 years from retirement), bonds are still great. If you treat them just like “less risky stocks” and buy a bond fund, they will dampen your volatility and make it less likely that market downturn will put you in a bad situation right when you are about to retire. This is basically what target retirement funds do, and that’s okay for many people.

But you can do even better if you don’t just treat them like stocks. Instead of a bond fund, consider building a ladder of fixed income investments to match up and provide you the money you need when you need it. You’ll gradually ramp down your stock exposure while you gradually ramp up a much safer (and more predictable) fixed income investment. Just be sure to stick to safe fixed income investments like treasuries or CDs rather than something that behaves more like a stock. Corporate debt hasn’t rewarded investors that well over time and stay away from more exotic fixed income assets (like CDOs or junk bonds) if you’re in this situation!

In short, keep your risky assets risky and your safe assets safe, and vary between the two depending on your risk tolerance and time horizon. The stuff in the murky middle is a trap!

Why I Don’t Own Bonds

So why don’t I have any bonds right now? Well, let’s look at our criteria:

My time horizon is fairly long (at least 20 years before I expect to need to draw on my funds)
My volatility tolerance is fairly high as evidenced by how I responded to the 2008 financial crisis and other stock market swings
High expected returns (or what pass for them in this environment) are critically important for me, given that my goal is to build a retirement nest egg

So… at least in my retirement portfolio, bonds are not right for me. I don’t believe that adding bonds will increase my returns, and I am comfortable taking on additional volatility to improve my expected returns. Note that this is not true for me across the board: I do have shorter horizon parts of my portfolio (e.g. my emergency fund) invested in very safe fixed income assets (e.g. a CD ladder).

Back to my retirement portfolio. I’m actually being even more aggressive than 0% bonds. As a believer in the benefits of time diversification, I am following a value path that puts me as high as 200% in stocks (using leverage) right now, with a plan to significantly reduce that exposure as I near my retirement goal. That leverage is approximately the equivalent of holding negative bonds, since margin is a loan to me. It’s actually closer to negative cash, but for the purposes of this argument, the two are close enough.

This approach isn’t right for everyone, but is a logical extension of the thinking above about when bonds are and are not appropriate. Suffice it to say that over the next decade they will become a critical part of my portfolio as I first reduce my leverage, then build out a ladder of fixed income assets to cover my expenses each year.

Other Considerations

Now that we’ve talked about why you would or wouldn’t want to use bonds in a portfolio, let’s cover a few other important odds and ends:

First, note that in comparison to stocks, bonds are usually tax inefficient. Interest is taxed as income vs. long term capital gains and qualified dividends at a lower rate. In a tax advantaged account, this won’t matter, but it’s worth considering as you invest taxably. I plan to hold my fixed income assets in tax advantaged accounts whenever possible and do my taxable investing primarily with stocks. If I run out of tax free space, I may consider municipal bonds, which have favorable tax treatments, but also other disadvantages.

Second, if you are concerned about maintaining purchasing power over time (as you may be if you are living off your investment income in retirement), consider bonds that are indexed to inflation (e.g. TIPS). Rather than paying out a nominal interest rate, these bond’s interest and principle are guaranteed to go up as prices rise. This protection isn’t always useful and theoretically should reduce prospective returns, but I will strongly consider these types of investments while planning my retirement disbursement stage.

Finally, I want to highlight and repeat my warnings about treating bonds as “less risky stocks.” They aren’t, and if you treat them this way you lose out on many of their advantages. If you buy risky fixed income investments like junk bonds, realize that they may go to zero. In general, I’d argue that you are better served taking on this risk in equities. You could diversify across many risky bonds to reduce risk, but I don’t like bond funds. Why pay an extra fee to diversify away default risk when you could just buy individual bonds from the U.S. government literally for free? No need to diversify if the default risk is zero. If you’re concerned that the government is going to default, you should probably spend your money on guns and gold bars anyway… so unless you need the convenience, bond funds are a waste. Build your own ladder of individual safe issues.

Conclusion

And that’s my word on my bonds. Not right for me right now, but definitely a core component of my future. Maybe right for you? Yes, if low volatility and pay certainty matter.

Just don’t call them “low risk stocks.”

Your Actions for Today

Do you have bonds in your portfolio right now, either directly or via something like a target retirement fund? Consider whether bonds make sense for you and if you could get better results by adjusting your asset allocation.
Do you have any questions for me? Your answer could be the next thing that’s easily done!