Why Own Bonds in a Portfolio?

Following my last post on the historical performance of long-term treasuries, a few people asked me if I was implying that bonds have no place in a portfolio at these interest rate levels. That was definitely not my intention.

Even at ultra-low interest rates around the globe, bonds deserve a place in a portfolio for a number of reasons. I just think there are a few things bond investors need to understand about longer maturity bonds, so I was pointing out the possible risks. Here are some other considerations:

Diversification benefits. High quality bonds protect investors during times of market stress and deflation, providing a diversification benefit with little-to-no correlation to stocks in the short-term.

See also: There’s no such thing as precision in the markets & How often do stocks and bonds decline at the same time

Bonds don’t crash like stocks. Unless we were to see an enormous re-pricing of interest rates happen overnight, in a magnitude never seen before, bonds don’t necessarily crash like the stock market (this depends on quality and maturity though).

See also: What does the bursting of a bond “bubble” look like?

Higher yields require higher levels of risk. All else equal, the longer the maturity in your bond holdings, the higher the yield. But longer maturities also lead to higher volatility, which is actually even higher at lower interest rate levels.

See also: How interest rates affect the behavior gap & How the markets tempt us into making mistakes

Bond investors have to set reasonable performance expectations. Interest rates have fallen a great deal since the early 1980s. The bond bull market is now well over 30 years in length. Even if rates don’t rise from here, fixed income investors have to understand that the historical performance in bonds since the 1980s cannot be repeated from these yield levels for very much longer.

See also: Resetting bond return expectations & Back-testing the Tony Robbins All-Weather strategy

Total return matters more than yield. Bond substitutes with higher yields may look enticing, but they come with their own risks. Because of the way bonds are structured — think about bonds like a mortgage or loan — they are far less risky in terms of losses than dividend-paying stocks, preferred stocks, convertibles, bank loans, REITs and the like.

See also: What’s an investor to do about bonds?

Bonds provide and emotional hedge. Finally, bonds offer investors something of an emotional hedge against poor behavior. Not every investor is willing or able to have their entire portfolio in the stock market. There’s no use in trying to implement a risky portfolio strategy if it’s going to be impossible for you to stick with it. Bonds can help by providing stability in the event of a market sell-off in stocks.

Even if they were to fall in a down stock market, it wouldn’t be very far. In this respect, bonds can as a source of funds for either rebalancing into stocks at lower levels or for spending purposes for cash flow needs. But they also give risk-averse investors the stability they crave to balance out the craziness of the moves in the stock market.

 

 

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  1. My Own Advisor commented on Jan 11

    I always like Andrew Hallam’s take on bonds, they are parachutes for your portfolio – given not every investor can stomach large stock market declines.

    That said, if you can fight that urge to sell stocks when things are tanking, and instead buy more, I think you don’t need to own bonds until retirement age when it’s essential to preserve capital.

    Just my $0.02.
    Mark

    • Ben commented on Jan 11

      I like the analogy. I definitely think bonds make sense for those that can’t fight the urge (which include many investors). But you’re right, for those that can stand the swings, a de-risking approach in the later years makes sense too.

  2. jswede commented on Jan 12

    how about bc they can provide great returns? I use TMF to mimic a long Treasury strip. It returned well last year. Similarly, municipal bonds have had huge returns.

    • Ben commented on Jan 12

      Yes this is possible in any given year, but over the longer term bonds generally return close to their yields.

      • jswede commented on Jan 12

        if you are a passive holder, yes.

      • jswede commented on Jan 12

        said differently, thinking about bonds the way you just described is why most people missed out on that 100% I made last year in TMF

  3. A Low Rate World - Weekly Market Recap | Percension commented on Jan 12

    […] Why own bonds in a portfolio? I talk a lot about bonds in these weekly Market Updates. This article does a good job of expanding on some of my rationale behind the benefits of owning bonds. […]

  4. Marc Gordon commented on Jan 12

    I think you missed perhaps the most important reason, which is bonds provide a source of income, and capital to liquidate, during a bear market so that you never have to sell stocks in a bear market. A key to investing is the old saw, buy low, sell high, which in other words means NEVER SELL IN A DOWN MARKET! But if you do not have a bond ladder that you can live off of when the market tanks, you do not have an alternative. Holding a bond ladder that you can liquidate when the market is down provides the alternative to selling stocks at the worst possible times, and allows you to wait until the stock market recovers. When he market has recovered and stocks are again more expensive, then rebuild the bond ladder in preparation for the next downturn in the stock market. This is a key part of the path to being a successful investor.

    • Ben commented on Jan 13

      Yes, great point. Bonds can act as a source of liquidity for rebalancing purposes and to buy stocks on sale. One of the best reasons there is.

  5. Saurabh commented on Jan 13

    Hi Ben, your website is very educational and I like the statistics that you provide. What software can I use to play around and do some backtesting or generate meaningful stats for ideas that I have?

    • Ben commented on Jan 13

      Thank you. Here’s a very basic, free tool that works best for asset allocation models:

      https://www.portfoliovisualizer.com

      If you’d like o do some more in depth back-testing on specific stock picking strategies, check out:

      http://www.portfolio123.com

      P123 does have a subscribtion cost but it’s not super expensive. Let me knoe what you think.

  6. Erin commented on Jan 21

    Ben,

    Thanks for the article. I’ve been toying around with a modified Permanent Portfolio to use for my taxable account. Since I may be living off of it in a year or two I wanted to keep volatility real low. I found 30% equity (divided 15% US small caps, 10% int’l small caps, and 5% REIT), 20% long-term treasuries, 35% intermediate, and 15% gold back-tested really well (at least to 1972).

    Of course the future is not the past and I’ve been worried about the likelihood of low bond yields in the future. Do you think I should increase my equity ratio? Use a traditional 60/40 split? I like the idea of having gold for inflation risk and long-term treasuries for deflation but I can envision a future where interest rates and inflation remain low for years which would be bad for returns on both.

    • Ben commented on Jan 21

      I like the fact that you have covered all of your bases with a diversified portfolio. Honestly, at the end of the day increasing an allocation +/- 5-10% in either directions matters much less to your overall returns than your ability to stick with your strategy over time and rebalance periodically to manage risk.

      A few other thoughts for inflaiton hedges in lieu of gold: TIPs or possible precious metals stocks:

      http://awealthofcommonsense.com/opportunity-precious-metals-stocks/

      No perfect scenario for every asset class so you utilize the good ones for spending/rebalancing purposes and eventually the poor performers will come back. Just have to be patient.

      Also, here’s a good one on the potential for lower bond returns using a historical period for the lower yield environment you talked about:

      http://www.financial-planning.com/fp_issues/43_3/Bond-Analysis-last-six-decades-can-tell-advisors-about-future-2683414-1.html#Login

      • Erin commented on Jan 21

        Thanks for the quick and informative reply. I discovered this blog last night (redirect from Seeking Alpha) and I enjoyed both the information and your presentation style. I’m really dragging today at work from a lack of sleep!

  7. mpmassey commented on Jan 30

    In viewing your chart in one of your other posts regarding the long term returns of long bonds when current yield is under 3%, why would I want to diversify into almost certain loss, after effects of inflation?
    I see no place for bonds in my portfolio today. I would rather hold cash, thereby saving transaction costs and keeping powder dry for future investment in equities after a correction. And not like bonds do not have risk: credit risk, reinvestment risk, liquidity risk, not to mention rate and inflation risks.
    But I am not your average investor: I took out $150K on my HELOC in March and April of 2009 to invest in equities. It was like I found a gold mine a foot below the surface in my backyard then. Pure heaven.

    • Ben commented on Jan 30

      True, but remember those were long-term bonds. Short-term or even intermediate-term bonds could still do OK from these levels. Not earth-shattering but OK. See today’s post:

      http://awealthofcommonsense.com/real-risk-6040-portfolio/

      Sitting in cash in certainly an alternative. As long as you have some form of dry powder to buy stocks after future losses, I think that’s the whole point of it. I still see a place for bonds in someone closer to retirement age, but for bigger risk-takers such as yourself, you’re probably right to not be in bonds.