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Really? Do I Need Bonds?

When you are buying equities, or stocks, you are buying part of ownership in a company. The price of stocks greatly varies and is affected by a lot of factors but in broad terms, the price is determined by the potential future earnings. If a company is seen by investors to have great earning potential, they will be ready to pay more to get a piece of the action than if a company is showing meager prospects.

Stock prices can jump up as fast as they can drop down and so the risk associated with stocks is perceived to be high. You can always mitigate this risk by diversifying into a lot of different stocks such as buying an index fund or you can lower your exposure by holding other investments such as bonds.

 

Bonds are boring. They are made to be boring.

A bond is a debt investment where you loan your money to a company or a government for a defined period of time at a fixed or variable interest rate. They are designed to stay relatively steady and generate income for the debtholders. Bondholders do not get a share of company’s profits but rather collect interest at an agreed upon rate.

If a company finds itself in financial troubles, the stock would tumble and might even go to zero but bondholders get priority claim over stockholders if the company gets dissolved. In other words, if the company has any assets, such as equipment or inventory, the bondholders would get paid back before any money goes towards the stockholders.

For the issuers, it is a simple way to raise capital for new equipment, new schools, or new war efforts without giving away equity.

 

Why buy bonds?Source: Vintage Ad Browser

 

For the holders, bonds hold two main functions; hedging against equity risk and generating steady income. By holding a diverse portfolio of stocks and bonds, you can choose the level of risk and reward you wish to take on. Bonds tend to return less but have been historically steadier than stocks. The chart below shows the growth of $1 invested in stocks using the S&P 500 Index versus $1 invested in bonds using the Barclays Capital US Aggregate Bond Index.

 

Should I invest in bondsSource: Russell Investments

 

As shown, over this time period, an investor would have made $112 out of his dollar in stocks compared to only $24 if he had invested in bonds. The choice seems obvious. However, just look at the chart now and notice how bumpy the stock roller coaster was compared to the smooth sailing bonds. In rough times, bonds will be there to balance things out and that is their main attraction.

Investing in bond-index funds, such as the Vanguard Total Market Aggregate Fund (BND), involves inflation and credit risk but long-term returns have historically been stable. According to the average rollover of the fund, the risks are minimal if you are holding it for over 7 years.

 

The average maturity of the Vanguard Aggregate fund is about seven years, which means that over that period, its entire portfolio has been rolled over to new bonds. It also means that it is virtually impossible to lose money by holding this fund for seven years, – Cullen Roche

 

The fixed income market has been disappointing lately, now that interest rates are so low, but over the long-term, bonds should still provide considerable returns. However, there is room for fixed income in a portfolio even in a low-rate environment.

 

Managing risk

The main benefit of holding a good part of your portfolio in bonds (let us use a balanced 60% stock / 40% bonds allocation) is that you will be able to sleep well during the next major crash. During the latest bear market in 2008, we saw stocks plummet drastically but the  Barclays U.S. Aggregate bond index had a positive return of more than 5% in 2008 and almost 6% in 2009. A balanced portfolio would have dropped but not nearly as much as a 100% stock allocation. Depending on your risk profile, you might be tempted to sell when your portfolio falls 40% but that is exactly the worst time to sell! Holding a good part of your assets in bonds will lower the swings of your portfolio and might save you from selling at the bottom.

 

Historical Returns (1926–2016) for a 60% Stocks, 40% Bonds Portfolio
Average annual return 7.8%
Best year (1933) 27.9%
Worst year (1931) –18.4%
Years with a loss 16 of 91

 

Looking at historical data from 1926 to 2016, Vanguard compiled the variations in different portfolios. For a balanced portfolio, the worst year only drops 18.4%. On the other hand, if you look at a 100% stock portfolio, the worst year dropped your portfolio’s value by a whopping 43.1%.

 

Historical Return (1926–2016) for a 100% Stocks Portfolio
Average annual return 10.2%
Best year (1933) 54.2%
Worst year (1931) –43.1%
Years with a loss 25 of 91

 

If you are risk-averse, the worst thing you can do is sell at as soon as you see your portfolio drop 43% but having bonds would have enabled you to keep your calm, hold on, and ride the market back up.

 

Withdrawal strategy

Even if historically, a 100% stock portfolio has returned more than a balanced portfolio, Monte Carlo simulations actually show a higher chance of success when you add some bonds. Running Monte Carlo simulation using available historical returns data from January 1972 to December 2016. The historical return for a 100% stock portfolio for this period was 11.71% mean return (10.18% CAGR) with 15.53% standard deviation of annual returns.

Using the 4% rule and historical inflation with 4.02% mean and 1.32% standard deviation based on the Consumer Price Index (CPI-U) data from January 1972 to December 2016, the simulation calculated an 86.23% chance of success over a 30-year period.

Now, when using a balanced portfolio with a 60/40 asset allocation, the historical return for the same period was 9.30% mean return (8.76% CAGR) with 9.35% standard deviation of annual returns. Lower returns indeed but the chances of success over a 30-year period now jumps to 97.64%.

As shown, having a nice cushion to smooth the ride is crucial when in the withdrawal phase. Having bonds will minimize the need for you to sell stocks during the worst bear markets. As discussed earlier, selling stocks at their lows is not preferable so if you are depending on a withdrawal rate to live, having bonds would allow you to hold on and ride the market back up.

Another option would be to hold a year or two’s worth of living expense in cash but then you would miss out on potential bonds returns. They have been low lately but, historically, has returned more than cash-equivalent holdings.

 

Buying the dip

If you are not withdrawing and are still in your accumulation phase, bonds could also be used as a lever when stocks do very poorly. You could sell bonds while they are high (assuming they keep their value in during that crash) and buy stocks when they are low.

This can be achieved with cash too, we currently hold our money in a 1.90% savings account on top of the 5% to 10% of our portfolio in Vanguard’s Total Bond Market index fund.

In a situation where the market would dip considerably, you could sell some bond index fund and buy some Total Market Stock index fund for cheap. This might sound like market-timing. Well, that is exactly what it is. However, this strategy offers all the benefits of bonds mentioned above and our bond allocation is so low that we might consider it a reasonable gamble to take.

If we see our portfolio cut by 40% in the next crisis, our 5% to 10% bond allocation will not really smooth the ride as much as a balanced portfolio would. We are talking about a few percentage points difference compared to a 100% stock portfolio. However, switching these into equities would greatly increase our total returns if the market then goes back up.

Should you buy the dip

 

Using the fictional representation above, doing a switch from a 90% stock to a 100% stock portfolio anywhere in the blue zone would increase our total returns. From the absolute bottom of a 40% drop (it is impossible to time it but let’s use a round number for the math), our new purchase would have grown 66.66% once it recovered to its original high. Our total portfolio value would then have grown 16.67% more than if we had kept the same allocation. Of course, this assumes that the bond market would be steady, or increase, at the time when the stock market is crashing. Another big assumption here is that you are able to buy within the blue section. If you do not buy near the bottom, you are missing the dip.

So in the end, a 10% switch from bonds to stocks increased returns 16.67% in our fictional recession. The lower your portfolio dips, the more profitable this switch would be. In this example, we used the absolute bottom of 40% but this is nearly impossible to do in real life.

We highly discourage market timing since it is a gamble. When will it be profitable to buy the dip? Will you miss opportunities waiting for the right time? No one knows.

 

when to buy the dip

 

The chart above shows a real market this time. If you had been waiting for the right time to buy the dip, would you go at the first or second drop or those were too slim? What if you finally went on the fourth dip? Then, you would have probably been better off with a 100% stock portfolio from the beginning.

Holding on for too long, in the hopes to buy the dip, might not increase your returns. The yield on a U.S. 10 Year Treasury Note, pretty much the safest bond you could get, has fallen from 14% in 1984 to 8% in 1994 then to 4% in 2004 and to under 2% today.

 

The verdict

In the end, we choose to hold bonds to smooth out our returns, while holding a certain security in case of emergency or opportunity. The reason we hold some bonds, although a very little percentage of our total portfolio, is to have flexibility. The flexibility to buy the dip if we feel like it. The flexibility to use it as an emergency fund if we go through our current savings. It will not save us from the next crash but again, what would?

Xyz.

 

18 Comments

  1. Being already in FIRE mode, we’ve recently decided to add bonds to our portfolio too. We’re at 30% right now and will expand that to 40% over time. We didn’t do it right away because we are managing tax implications of shifting our portfolio mix.

  2. Great post! I hold about 20% bonds and I really think that is too much. I sometimes wonder if I should hold any at all and go 100% stocks since I am planning on investing for a very long time. I like the buying in the dip strategy. Might be a good way to reduce my bonds % in the long term.

    • Xyz

      October 7, 2017 at 10:01 am

      It’s a great way to reduce your allocation, if that’s your plan, simply switch when stock prices are advantageous 🙂

  3. Great post and detail. Bonds are out of fashion now because of the low interest rates and making money is stocks seems easy. The fear that I have for investors is that they think the next correction will be like the 08-09. There was a sharp decline followed by 8 years of great returns. I don’t have a crystal ball, but the next correction could be like the 4 years of negative returns from 00-03. Can investors hold 100% in stocks for many years of negative returns with no hope of things getting better?

  4. Dear Xyz,

    We’re selling our home and I’m looking to put the money into a “liquid” investment (we’re 90% in stock and will be retired in three years).

    Everyone talks about bonds in retirement but what about GICs? I’d love to read your take on the two.

    Besos Sarah.
    Fellow Canadian

    • Xyz

      October 1, 2017 at 10:01 pm

      GICs are great when you have a fix time frame. In your case, I doubt you will actually use all that money in 3 years, you will just need a part of it. You could always do a GIC ladder (maturities in 2020, 2021, 2022…) and plan cash-flow this way. However, bonds should return slightly more than a GIC ladder over the long term. Many years such as 2009, 2010, and 2011 saw 6%+ returns in bonds funds but GICs averaged around 4%. After inflation, GICs return near to 0% but bonds tend to beat inflation. Here is a paper by Putnam Investments that shows historical returns of CD (American equivalence to GICs) and bonds https://www.putnam.com/individual/mutual-funds/cd-vs-muni-bond-tool/

      • Dear Xyz,

        Thank you very much for the explanation and link. I have a lot to learn.

        I hope to never have to touch the bonds, GICs or “cash” (whatever I buy) at all. I want to keep it as an emergency fund for the emergency fund and/or a mental security blanket to my anticipated anxiety when the markets adjust. So, if it keeps up with inflation then I’m okay with that. I can’t believe I just wrote that but it’s true.

        While my husband isn’t officially retired, he is currently (and will for the next three years) take a dividend from his corporation (money has already been made and is sitting there). So, in a way, I’m done with the “savings” phase of our financial journey and onto the “maintenance” phase and then the (possible) “drawdown” phase in three years (but if everything goes to plans, our passive income and social security will cover 110% of our needs).

        I look forward to your future posts.

        Besos Sarah.

        • Xyz

          October 2, 2017 at 6:47 pm

          Yes, a healthy emergency fund is always a good thing to have. We hold ours with Alterna Bank, they offer 1.90% interest and do not charge any fees.

  5. Our bonds make up less than 5% of our current portfolio. Our stance (driven by youth and no kids) is essentially why we would need bonds. There’s another blogger friend of mine who made a strong case for all stock (all like 100% without fail.) My husband and I wanted to check out treasury bonds although even the bond markets are inflated as well from skittish investors. Such a tough call…

    • Xyz

      October 4, 2017 at 9:54 am

      For now, I hold 5% Vanguard Total Bond Market and Mrs. holds 10% of her portfolio in it. We are the same, young, no kids, and are considering a 100% stock portfolio but that little five or ten percent just feels right. Very tough call…

  6. I’ve had a 10% bond holding for awhile now, and I’m planning to transition to holding 5 years worth of expenses in bonds when I retire and no longer have income. I’m not sure what the percentage will be, but if all goes well, it will be a decreasing percentage as time goes on and our portfolio increases in value.

    If we hit a rough bear market and I’m forced to choose between selling stocks or bonds, I’ll start depleting the bond portion until we see a meaningful recovery. It’s not unlike the “cash cushion” that other plan to keep.

    Cheers!
    -PoF

    • Xyz

      October 4, 2017 at 9:51 am

      Exactly, once nearing retirement, we plan to do a similar move. Great way to stay in the markets once the big crash hits.

  7. Why would I buy bonds right now instead of holding it in cash? Bond rates are expected to go up, thus prices will go down and result in losses. While cash doesn’t pay much right now, at least it is not a loss.

    • Xyz

      October 16, 2017 at 8:20 am

      True, they might go up. However, over the long-term (7 years, as quoted in the article) bonds should perform better than cash. It all comes to market timing. If you think you can time your entry, then it might work.

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