Why we Invest in Bonds

This last May I attended a conference in San Diego put on by our favorite brokerage firm, Shareholders Service Group.  I had a great time, learned a lot and was able to put faces to the people I speak with daily. I’ve spent the last month going through the information and have the following thoughts about our keynote speaker Dr. Christopher Gezcy, Academic Director of the Wharton Wealth Management Initiative & Adjunct Professor of finance at the Wharton School.  Basically Dr. Gezcy, who is an expert in portfolio diversification, says that we need to lower allocations to fixed income and invest in “alternative Investments”.

Now most of us can not invest in “alternative Investments” even if we wanted too.  They have extremely high minimums (a million dollars) the expenses are ridiculously high, often over 3%, are approved only for accredited investors, which we will all be, as soon we win the lotto.  But from an academic point of view Dr. Gezcy is correct – Alternative Investments do add great diversification to a portfolio.  Alternatives are usually called hedge funds, or long/short funds. I hate to disagree with a PhD from Wharton, whose IQ makes mine look puny, but here is what I think.

It’s hard to find anyone these days that likes fixed income investments.  One of the main concerns I often hear about is the so called “Bond Bubble”.  Interest rates today, while up slightly in recent months, are still close to an all-time low, thanks to the FED Bond buying, and poor demand on the part of borrowers in our sluggish economy. The fear of owning bonds has reached an unprecedented and in my mind unwarranted level. There is still good reason to own bonds in your portfolio.

Even PIMCO bond guru Bill Gross sent out a warning in a recent Investment Outlook newsletter, sayingthe staggering amount of debt in the United States has created a “credit supernova” that could crush the bond market as the global credit bubble “is running out of energy and time.”  Now, I don’t know exactly what that means but is sounds very dire, and somewhat astronomical.

Warren Buffett doesn’t like the idea of having a fixed allocation to bonds either. During a CNBC financial news network interview, Buffett said “It’s silly to have some ratio like 30%, 40%, or 50% in bonds. They’re terrible investments right now.”

Many advisers are quick to point out the protection bonds offer from a falling stock market. In general a fixed allocation to bonds will cushion the blow of falling equity prices. That happens sometimes, but not always. During the 1970s, higher inflation pushed bond prices down right along with stock prices. Both markets suffered together.

The biggest factor discouraging the use of bonds now is the fact that they will most likely lose money even if interest stay where they are. About a month ago a 5-year Treasury bond was yielding about 0.8%. However, the real return rate is closer to -1.2%. This is the return you get after inflation and before taxes on interest income. The after tax rate of return is even worse.

With bonds, we find ourselves in a situation where there is talk of a price bubble; diversification isn’t guaranteed and we’re sure to lose money. Finding someone who likes bonds today is like finding someone who likes throwing rocks at a hornet nest.  I don’t enjoy bee stings, and I’m certainly not enjoying the low rates on bonds.  Yet I do believe there is a good reason for most people to own bonds.

 

Bonds, with all their problems, provide an important portfolio function. They give protection against a certain type of risk — the worst type of risk — a risk than can permanently devastate a retirement account. A risk that is building every day as the stock market hits new highs. A risk that ultimately crushes many investors during steep stock market slides. OK enough suspense.

A bond allocation helps protect a portfolio from its owner.

Nothing causes investors to forget history faster than a bull market in stocks.  As stocks hit new highs and portfolio values rush to higher valuations, memories of bear markets float away like balloons at the county fair.

Investors become brave when markets are moving up and the bears have been trampled. How people felt during the past bear market is a distant memory. Some even start believing those four fatal words that eventually cause so much capital destruction in a portfolio: this time it’s different.

Perhaps it is different this time, but people aren’t different. If a person couldn’t stomach a high allocation to stocks during the October 2007 to March 2009 market meltdown, then they won’t be able to handle the next one.  It’s not different this time.

Holding too much in stock and selling when stocks are down is so much more costly than holding a lower allocation (and rebalancing) through a complete market cycle. It’s better to invest less and hold on than to invest more and panic sell.  This is why bonds belong in our portfolios.

Bill Gross may be right that bonds are in a bubble and Warren Buffett may be right that they’re a terrible short-term investment. I believe a bigger danger lurks for investors who follow short-term advice and shift their portfolios from bonds to a higher stock allocation.

Investing in bonds is a hedge against bad investment decisions. They may not earn a high return going forward and may even lose some in the next down market, but I believe the psychology of holding bonds will stop some people from doing the wrong thing at the wrong time. A portfolio with a fixed bond allocation helps reduce behavioral risk and leads to a higher probability for long-term success.

I’d rather throw rocks at a hornets nest than invest in a hedge fund.  At least my pain will be temporary.



Share This On:
facebooktwittergoogle_plusredditpinterestlinkedinmail