Why would anyone own bonds now?
Many investors have been saying for years that rates can only go up from here, rates can only go one direction, rates will eventually go up. Will they? This begs a question I get from readers from time to time given bonds pay such lousy interest:
Why would anyone own bonds now?
Today’s post shares a few reasons to own bonds including some counter-arguments why I don’t own any – at least right now.
Why own bonds?
Personally, I believe the main role of fixed income in your portfolio is essentially safety – not the investment returns and certainly not the cash flow needs. In other words, if all else fails per se, if/when stocks crash, then bonds should historically speaking offer a flight to safety for preserving principal.
So, they are there for diversification purposes.
As Andrew Hallam, a Millionaire Teacher has so kindly put it over the years: when stocks fall hard, bonds act like parachutes for your portfolio. Bonds might not always rise when the equity markets drop. But broad bond market indexes don’t crash like stocks do.
Is that enough to own bonds in your portfolio? Maybe.
Here are a few reasons to own bonds in no particular order.
1. Bonds as a hedge for stock market volatility.
Call them parachutes or anchors or use any other metaphor you wish but bonds tend to do their jobs when stock markets tank. More importantly maybe, they provide a psychological edge to avoid tinkering with your portfolio and selling any stocks/equities when stock markets correct.
Many investors, dare I say most investors (?), have a hard time with market volatility. I’m certainly not immune to it. The ups and downs, especially the big market downs, can be gut-wrenching to live through. Owning bonds in your portfolio can help bring the overall portfolio volatility down a few notches through prudent asset allocation. It is however not always necessary to own bonds.
When you own bonds, my experience has been for the last 20+ years you are trading away long-term, more positive, generous equity returns for accepting less risk and less long-term returns.
If you don’t want to take my word for it, check out this page courtesy of Vanguard when it comes to long-term returns. Check out the “worst year” stats as well.
Sure, a 40/60 stock/bond portfolio has hardly done poorly for the last century. But overall, you are absolutely giving up (historically speaking) returns on the table when you own more fixed income in your portfolio. Will the future be the same?
Personally, I’ve tried to learn to live with stocks as much as possible for as long as possible. Depending on your goals, taking into account long-term potential reward against short-term price fluctuations, some investors may not be comfortable with a 100% equity or near-equity portfolio. That’s A-OK. If that’s your case, some bonds in your asset accumulation years could be right for you.
2. Bonds can be used to rebalance your portfolio.
Even though I’m not a huge fan of bonds myself, this might be one of the most compelling reasons to own bonds at any age.
When the stock market sells off, that’s ideally the time you want to dive in and buy your stocks on sale. However, unless you are very comfortable with leveraged investing – you need money to buy such stocks on sale. That can come from cash savings for sure but for many investors, that can also come from bonds within your portfolio.
Mind you, some levels of diversification don’t work very well if you don’t have any asset allocation targets in mind. The process of rebalancing is a systematic way to buy low and sell high; sell your bonds when markets are tanking and sell-off some stocks when markets are euphoric.
In our portfolio, because we’ve largely learned to live with stocks, we tend to buy more stocks when they come on sale and/or we buy stocks periodically during the year to increase our equity holdings. More specifically, to help me gravitate away from my bias to Canadian dividend paying stocks for income we’re owning more low-cost U.S. ETFs for extra growth over time.
Instead of selling bonds to buy our stocks, I use cash savings. I tend to save up cash during the year and make a few lump-sum stock or equity ETF purchases instead.
I will continue to use cash savings to make more equity purchases as I enter semi-retirement.
Consider keeping this much cash on hand yourself – in your asset accumulation years or retirement years.
3. Bonds can be used to spend cash when essential.
Can you have too much money saved? Too much money in your RRSP?
For most people, I highly doubt it.
At the end of the day, having a nest egg in your 50s and 60s that forces you to navigate the tax implications of your RRSP decisions is a great problem to have.
However, if you needed to tap your RRSP or any part of your portfolio in an emergency, for a big expense, then selling off fixed income assets can be the best decision you can make.
Big picture, stocks tend go up more than they go down. The problem is, we simply don’t know when nor by how much. Yet thanks to the power of long-term human productivity and innovation over time, unless something changes, stocks should continue to rise more over time and deliver returns to investors who ride equity markets accordingly.
Should you need to access your portfolio for any financial lifeline, then consider selling some bonds for cash. At least that’s my thinking.
Why would anyone own bonds now summary
No doubt the list goes on…
Generally, investors who plan on holding their bond until maturity typically don’t need to worry about the movement of bond prices on the secondary market as they will be repaid their principal in full at maturity, barring a default. But for those looking to sell their securities sooner, an understanding of what drives secondary market performance is essential.
- The price of a bond relative to yield is key to understanding how a bond is valued. Essentially, the price of a bond goes up and down depending on the value of the income provided by its coupon/interest payments relative to broader interest rates.
- If interest rates go up, bond’s coupon/interest rate becomes less attractive. In this situation, the bond price drops to compensate for the less attractive yield.
- On the flip side, if interest rates drops, the price of the bond goes up as it becomes more attractive.
For example, if a bond has a 4% coupon and the prevailing interest rate rises to 5%, the bond becomes less attractive and so its price will fall. On the other hand, if a bond has a 4% coupon and the prevailing interest rate falls to 3%, that bond becomes more attractive which pushes up its price.
We could discuss bonds as a hedge for deflation (since inflation is a killer for bonds long-term). When there’s inflation, your bond income is worth less over time, but in a deflationary environment, they’re actually worth more. So, some investors might own bonds as a hedge for any recession.
However when it comes to owning fixed income I believe these three (3) key reasons come to mind:
- Bonds can help your investing behaviour – helping you ride out stock market volatility – including being strategic to buy more stocks soon.
- Bonds can be used to rebalance your portfolio – helping you keep your portfolio aligned to your investing risk tolerance and therefore asset allocation (mix of stocks and bonds).
- Bonds can be used for spending purposes – where some fixed income is “king” for major, upcoming, near-term spending.
The main reason I would keep any bonds (and I still don’t have any right now) is if I was saving for a major purchase in a few years (e.g., secondary residence?). Then, I would like rely on some form of fixed income between now and then to help secure that purchase. Otherwise, an interest savings account in the short-term will do that.
Unless something drastically changes, I will continue to believe the main role of fixed income in your portfolio is essentially safety. You don’t invest in bonds for high returns or even mediocre returns.
My plan is to hold a modest cash wedge as I enter semi-retirement and keep a strong bias to equities. I believe any cash needed in the short-term (0 months to 1-year) for any spending should never be in stocks. Cash only.
In fact, any cash you need for the next year or so, may be best held in a savings account for ease of accessibility and liquidity. I think any money you absolutely need/absolutely depend on in the next 1-2 years should likely be in cash or some form of fixed income. Then again, that’s my risk level and tolerance.
I suspect once I’m semi-retired and working part-time in a few years, my cash position beyond 1-years’ worth of expenses could grow. I don’t know. Time will tell. I figure I have 3-4 years to figure that out. 🙂
Some say how much you invest in stocks, bonds and/or cash might be the most important portfolio construction decision any investor ever makes. Quite possibly. Depending on your investment timeline, your need to take on investing risk for reward, and any need for near-term liquidity, you might not need any bonds in your portfolio now.
Thoughts on this take? Do you own bonds right now? If not, how are you managing your portfolio?