Broker Check

Why Not Bonds?

 

March 16, 2016

 

Dear Advisory Clients,

 

The purpose of this letter is to address a topic which I have discussed with many if not most of my clients several times, but is of sufficient importance to be committed to paper.  To make the bottom line the top line, my opinion is that the use of bonds is not currently appropriate for most (if any) investors in anywhere near the proportions often suggested by traditionalists. 

 

Portfolio management doctrine holds that every portfolio should be divided among multiple asset classes, and bonds or fixed income should constitute a substantial portion of that portfolio.  Furthermore, the closer one gets to retirement, the larger that category gets.  One often hears formulas based on age, suggesting that someone in retirement should allocate as much as 40% or more of their assets to fixed-income investments.

 

My opinion: While this may have been a suitable practice in a time when we had relatively short retirements, and when bonds offered more attractive yields than they do today, under the conditions which currently exist this approach is no longer (or at least not presently) appropriate.  Allow me to present a brief explanation for this opinion.

 

The assumption behind the traditional or conventional approach is that various asset classes do not perform in tandem or correlation with one another.  When stocks are doing poorly, other asset classes – bonds, real estate, commodities, etc., will not necessarily react the same way to the same stimulus, and may actually perform better.  No asset class performs well in all circumstances and no one can consistently predict accurately which asset class will perform well at any given time, and for how long. 

 

Bonds have always been considered the “safe” portion of the portfolio, and this is the justification for the large and increasing proportion as one ages.  This is also the reason I do not consider them appropriate now in more than nominal doses.  In my opinion, bonds are currently the most risky conventional investment one can make.

 

Ten years ago, one could empirically demonstrate a historic total return for long-term investment grade bonds of 7% or more.  Even today, one could probably justify a 5% historical assumption, and many of you would probably jump all over a “safe” investment yielding five to seven percent.  The problem though, is that the conditions under which those returns were obtained no longer exist.  On the contrary, presently, it is impossible to obtain even three percent on an absolutely safe, guaranteed investment (the benchmark 30-year treasury bond is, today, approximately 2.75% and many international yields risk adjusted are even lower).  So this means, if you are willing to wait 30-years to get your money back, you will receive 2.75% for this portion of your portfolio.  No more.

 

But that’s not the worst part.  The reason for the 7% average previously cited was derived from two no-longer-existent factors.  In February of 1980, that same 30-year US Treasury was yielding almost 12% (https://ycharts.com/indicators/30yeartreasury_bond_yield).  So (1st) if one bought such a bond and held it for 30 years, he received 12% per year on that investment.  And (2nd) if he decided or had to sell it somewhere along the way, he realized a tidy capital gain because of the premium paid for higher-yielding bonds in a falling-rate environment, which has existed ever since.  Today, by comparison, rates are the lowest they have been in my life time, and while some suggest that they will go lower, realistically they can’t go much lower, but more importantly, even if they do, they will not stay at those levels.  So the capital gains which contributed to those 7% total return numbers of yester-year literally cannot be duplicated in any kind of economic environment one would realistically expect (or hope for!).

 

But what of my suggestion that bonds are the riskiest conventional investment available?  I believe this because, while the current yield is reliable, it is rare that an individual will hold any investment for 30 years.  Shorter maturities have lower interest rates and some international bonds actually have negative yields!  If, in ten years, you find yourself in the market to sell a bond yielding under 3% with 20-years to maturity, it is exceptionally unlikely, IMHO, that you will receive the full face value of that bond.  It is much more reasonable to expect that rates will be higher (for new issues, not for the old ones you are holding), perhaps substantially so, and that you will have to accept something less than full value for your investment.  This risk to the liquidation value of bonds is the devil in the details; when the market begins to expect rates to increase, investors will head to the exits in droves.  In my judgment, bonds are the current investment bubble waiting to pop.  Such an event may not be imminent, but it nevertheless has the potential to be devastating if it does occur.

 

I have ranted on far longer than I intended when I began, but I believe the subject is an important one, which all of us should recognize and understand.  And fully consider in our investment decisions.  Because this is a firmly-held conviction for me, I have substituted blue-chip stocks with good and sustainable dividend histories and current yields for a significant portion of the portfolio which others more sanguine on the genre might devote to bonds.  To be clear: these investments, while they are not overly risky, are not “safe” either.  They can and will occasionally lose money.  But under current conditions, they are less risky than bonds, and there is a better expectation, not only of current yield, but also the potential for capital gains as well.  And in measured and diversified portions, they make far more sense. 

 

I realize this is a complex subject, and a more detailed conversation may be desirable with respect to your personal situation and portfolio.  I am more than happy to meet with you on the subject.  With or without a meeting, if you are not comfortable with my reading of the tea leaves, or with my stated reaction to it, let me know and we can adjust accordingly.

 

Best regards,

Jim Denton

James C. Denton, CFP®
Managing Principal

 

 

The observations and opinions expressed in this commentary are those of the author and do not necessarily reflect the views of NFP Advisor Services, LLC.  This commentary is for general information only and is not intended to provide specific advice or recommendations for any individual.  You should not take specific actions with regard to this information without first discussing with your primary advisor.