It doesn’t take a genius to understand that in today’s low-interest environment savers are being punished. The interest on your mortgage is very low but your savings aren’t earning much either. The typical current account interest rate here in the UK is 0.1% with some banks paying higher interest for a fixed amount.
As we climb higher the risk scale, we meet bonds. This article explains the reasons for owning bonds. Everyone knows that bonds are riskier than cash which is the risk-free option for our money.
But people don’t express their love for bonds lately and I can see why. The 10-year UK government bond (UK Gilts) pays us a measly 1.04% per year right now, with the US paying 2.47%. You would usually buy bonds through an ETF though, such as VGOV which right now yields 1.3%. Not high either!
So if you invest £1,000 you will get £13.00 back at the end of the year. Now that’s better than nothing but it’s quite a low return on your money. So I can see the “I don’t own any bonds” argument.
But why do bonds exist anyway if they pay so little? Are people still buying them?
Why you should own bonds
This is the global stock market next to the bond market between September 2018 – Dec 2018.
As we can see, global stocks fell 15% in 3 months while bonds barely moved. And here’s a 33-year graph between 1986-2019. One of the two portfolios is a classic 60-40, having 60% in global stocks and 40% in global bonds (unhedged). The other portfolio owns 100% global stocks.
How do you think they compare in a 33-year period? Can you tell which is which?
You can view my analysis on Portfoliovizualizer which I cannot recommend highly enough.
Portfolio 1 is the 60-40 and Portfolio 2 is a 100% global stock portfolio. Despite the fact that 33 years have passed, the two portfolios have very similar returns – but quite different characteristics. I could have cherry-picked the data to demonstrate my point even further, but I just picked the longest period Portfoliovisualizer could give me.
A 60-40 portfolio outperformed a 100 stocks one for 30 years! 1986-2016. There’s clearly some benefit in owning both, not only in terms of annual returns but also lower volatility. So if I had to provide a list of the reasons we hold bonds, it would be this:
1. Smoothing the ride
This is probably one of the most important reasons we hold bonds. We want our portfolios to make as much money as possible and meet our future goals, whether that’s sending our kid to college or a comfortable retirement. But none of it matters if we cannot hold onto our portfolios through the (inevitable) bad times.
Sometimes the tide is with us and sometimes against us. But we have to swim and keep moving, anyway.
I’ve recently heard the phrase: We should build portfolios that are “regret minimizers and not utility maximizers” which is so true.
A well-structured portfolio is one that takes into account how sensitive we as individuals are to its price movements. In simple words, a good portfolio should prevent me from selling at the bottom and topping up only at the top! Buy low sell high is easier said than done. See how the annual returns of a bond portfolio compare to the 100% stock one.
- Portfolio 1 (Blue) is 100% stocks
- Portfolio 2 (Red) is 100% bonds (10-year US treasury)
Forget 2008. Could you have handled 3-year double-digit falls in a row?
- 2000: -13.09% stocks vs 17.28% bonds
- 2001: -15.56% stocks vs 5.40% bonds
- 2002: -18.02% stocks vs 15.45% bonds
Even the 60-40 portfolio did relatively well compared to the 100% stocks one during the bad times.
Bonds are not a panacea as they can fall together with stocks but they are not highly correlated. This means that when US stocks sneeze and the UK catches a cold, UK government bonds cannot care less about it. Therefore, holding bonds prevents us from harming ourselves and selling when we’re not supposed to because of fear.
2. Keeping dry powder on the side
If you can stomach the stocks’ ups and downs then there is another reason you may be interested in holding bonds. Bonds can act as a dry powder for when stocks are on sale.
The best period to buy stocks is after a big crash. That’s when the valuations are more attractive and companies selling at a discount. But if your net worth is 100% invested in stocks then there’s not much left to rebalance. If you, however, keep a good portion in bonds or cash, then it’s much easier to make big gains in the years to follow. That’s because the biggest stocks gains happen usually after a big crash.
Personally, I find this being a very compelling argument for holding bonds. Not only my purchasing power is not lost by holding bonds but I can have a small “opportunistic pot” ready to be deployed. Whether that’s a stock crash, a business opportunity or a private investment.
Plus let’s not forget that bonds can and have outperformed stocks for long periods of time
Thanks to the low-interest environment we went from “stocks usually outperform bonds in the long term” to “stocks outperform bonds”.
If you think that long-term means that in any 10-year period, stocks should do better than bonds, think again. Let’s have a look at the recent data again.
Starting from 1986, stocks were doing better than bonds until they didn’t in 2002. So cherry-picking the 16-year period of 1986-2002, 10-year bonds outperformed a well-diversified global stock portfolio. And when stocks started shining again, 2008 happened. So at the end of the 23-year period (1986-2009), bonds outperformed stocks. If 23 years do not fall into your long-term definition, I don’t know what does.
Sure, the very high-interest rates of the 80s and their decline all the way to 2008 marked it as the golden era of bonds. But it doesn’t mean that stocks will outperform bonds moving forward in any 20-year period. It’s more likely that they will and I’m investing according to this probability. But I hate to say investing also has an element of luck in it. Which is why we need to hold both cards when we play.
3. Bonds as protection from sequence of return risk
The sequence of return risk says that it’s not only how much our portfolio will return on average after 20 years, but it’s how those returns will be given to us. In what sequence. When withdrawing from a portfolio, the sequence of return risk becomes extremely important. It can make all the difference between a successful portfolio and a failed portfolio with the same average returns but in a different order.
Bonds can protect us from the sequence of return risk. The worst thing that can happen when you need to start taking money off your stock portfolio, is to have a market decline. Not only you’re not buying at cheap prices, but you’re actually selling when you should be holding.
Losing 54% is a much scarier proposition compared to losing 29% when replacing 40% of our stock portfolio with bonds. Or losing 15% when 60% in bonds. A stock investor would greatly suffer from sequence of return risk if they began their retirement in 2000 or just before 2008.
Big Ern has written a very long article series on the sequence of returns risk that I highly recommend if you have the time. But to sum up, the early years of your retirement are the most important ones for determining your portfolio success in the long-term. So it’s very vital that your portfolio doesn’t lose much value in the first few years and bonds can offer this “insurance”.
How to shop for bonds
Ok, say I’ve now convinced you that bonds are still worth a shot even in our ultra low-return environment. How do we buy bonds and which bonds should we buy?
I love simplicity. It makes implementing the portfolio very easy which means that the probability you’ll stick to it is higher. I’ll keep it simple and say that for the vast majority of the population one bond fund is all you need. This can be a total bond fund such as the Vanguard Global Bond Index Fund (Acc). (ISIN: IE00B50W2R13).
The bond fund holds 10,700 bonds across the globe and of different maturities. The current yield is 1.82% and its currency movements are hedged. As a result, changes in the FX rate of other currencies won’t affect our bond performance.
You can also purchase government bonds of your own country if they’re high-quality. Here in the UK, we’re lucky to have such an ETF – the VGOV which only invests in UK government bonds.
Maturity, duration and jargon busting
We just said that the yield of the Vanguard global bond fund is 1.82%. What does this mean? It means that if you buy the bond fund right now, you will get an annual return of 1.82%, all else being equal.
But hardly all things remain equal. The most important variable affecting our annual 1.82% return is interest rates.
When bonds are popular, maybe because investors want safety, their price increase. This means that if you buy a more expensive bond yielding the same %, you should earn less in total. This usually happens when interest rates fall or during stock market declines.
Luckily, there is a metric called duration which measures how sensitive our bond is to interest rate changes. The higher the sensitivity the bigger the price movement in our bond price should interest rates change. For example, VGOV right now has an average duration of 12.9 years. This means that if its yield drop by 1% the bond price will drop by 12.9%. And vice versa, if the yield increases by 1%, then we should be able to sell our bond for 12.9% higher.
So by purchasing a bond, we’re lending our money for a fixed period. This fixed period is called maturity and can be anything, from 1 month to 30 years. The longer the bond maturity the higher the duration. So if I lend our money for 30 years, interest rate changes will drastically affect my bond price compared to, say, a bond with 1-year maturity.
This makes sense, because worse case, I can just wait until my 1-year bond matures instead of selling now at discount. Waiting 1 year is much shorter than 30 years so I’m taking a “small hit” to sell now.
Choosing a bond strategy
Depending on whether you own bonds as a short-term or long-term thing you should choose the maturity accordingly.
Personally, ~15% of our net worth is in bonds to smooth the ride of our other investments. I aim for a medium-term duration of 5-7 years. This strikes a nice balance between high-enough yield and low price movement (volatility). A medium duration will also allow us to deploy the bond stash into other investments if an opportunity shows up without being hit by a big change in our bond prices.
But I know some people who own long-term bonds and will own them for a long time. That’s fine because they’re not looking to change their allocation according to other opportunities and like the stability and higher yield long-term bonds can offer in a portfolio. Therefore, a long-term maturity makes sense for them.
One of the most well-known investors, Ray Dalio, actually recommends holding 40% long term bonds!
Especially when withdrawing from a portfolio, building your own bond ladder with different maturities is very useful to cover your future goals. But if you don’t have the time for building your own bond ladder, then a bond fund with an average maturity is a good enough solution. I like to keep things simple and move on with real life.
So, will you own some bonds?
Hopefully, I managed to convince you that in this low-interest environment bonds do have a place in a portfolio.
The earlier you are in life, the more stocks you want to own than bonds. That’s because the longer we invest for, the more likely is that our stocks will do better than bonds. If not, then why take the extra risk? Everybody would be buying only bonds instead, which is clearly not happening.
Bonds provide stability in our portfolio and can work well with stocks when we rebalance. When stocks go up we sell some to buy bonds. But when stocks crash, we use our bond portfolio to buy some cheap stocks for greater future returns. Together a mix of both will have a good chance of covering your future goals, whether that’s a penthouse in Miami or a small house in Symi, where I come from.
What does your portfolio look like? Let me know in the comments.
Disclaimer: This is not financial advice. You are responsible for your actions. As always do your own research.