bonds

Do You Really Need Bonds in Your Portfolio?

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In my guide on stock market investing, you may have noticed that I didn’t recommend bonds as a long-term holding. In event that you haven’t yet read my carefully prepared guide, here’s the basic portfolio I recommend for anyone getting started investing.

Portfolio Sectors and Weighting

This allocation is built using Vanguard index funds. It’s designed for anyone that’s in the accumulation phase of their investing career. Outside of the tiny bond holdings in the funds themselves, there’s no recommendation towards holding bonds. Why not? To best answer this let’s consider the reason why most people hold long-term bonds.

The most common reason why most people hold a substantial portion of their portfolio in bonds because they believe them to be much less risky than equities while providing guaranteed income.

My personal belief is that bonds are not best long-term instrument for accomplishing both of those goals (less risk with guaranteed income). Let’s dig into why.

Reasons for Owning Bonds

For the purposes of this discussion when I refer to bonds, I’m primarily talking about U.S. Treasuries and Corporate bonds.

Less Risk

If you ask your typical bond holder why they regularly buy bonds, you’ll get an answer along the lines of – “I own bonds because they’re less risky than stocks”. What they’re really trying to say is they own bonds because they tend to be less volatile than stocks.

It’s important to understand the distinction between risk and volatilityRisk represents the likelihood for a permanent loss of investment capital. Putting all your money into lottery tickets is a great example of a risky activity. Volatility represents market price fluctuations over time. Volatility will always be an aspect of investing in the stock market.

Let’s take a closer look at the “bonds are less risky” assertion. In the event of corporate bankruptcy, bond holders will have a senior claim on corporate assets. This means that they have a greater chance of getting a portion of their money back. The bond holder will typically receive pennies on the dollar. This is certainly better than the company stock holder who is likely to get nothing.

For me, bonds would be much more attractive if you were guaranteed to receive ALL of your initial investment should the company become insolvent. Sadly, this isn’t the case. This is a big reason why I don’t own any. In my book it’s just not worth it to buy AT&T the bond when I could buy AT&T the stock with far more upside.

Steady Income

While it is true that bonds tend to be less volatile than stocks over longer time periods, part of the price you typically pay for that stability is a lower yield and higher annual tax bill. Outside of municipal bonds, the income received is usually taxed at ordinary income rates.

This is in stark contrast to dividend-growth stocks. Depending on your tax bracket, qualified income from these investments is taxed anywhere from 0% – 20%. This is substantially lower than your bond income tax rate.

An advantage to bonds is the income they produce doesn’t fluctuate. If a note is paying you $1 per month through its maturity date, that’s what you’ll get. An increase or decrease in yield isn’t something you’ll usually experience with most bonds.

In comparison, the dividend yield from quality stocks is often much higher than what you’ll receive from a long-term bond. In well-run businesses, the yield also tends to increase over time. This increase in yield is one aspect of what makes dividend growth investing so attractive. Sounds awesome right? Unfortunately, there’s no free lunch.

If the company falls on hard times, the dividend yield can be lowered or suspended entirely. Although this is pretty rare for well-run companies, it can happen.

Alternatives to Bonds

 I’m a big fan of alternative securities over holding long-term bonds. Instruments like Real Estate Investment Trusts (REITs) and Master Limited Partnerships (MLPs) can provide a steady stream of income usually exceeding that of bonds. MLPs income also has the advantage of receiving very favorable tax treatment in comparison to bond income.

MLP Primer

Because most REIT income is taxed at ordinary income rates, they’re usually best held in a tax-deferred brokerage account like an IRA. For a quick primer on REITs and why you should consider them as an alternative to physical real estate investing, check out the following article.

A nice aspect of REITs and MLPs is that they often don’t follow the broader market as a whole. This causes them to reduce volatility in your portfolio similar to the way bonds do. There are also no bond-like “hold to maturity” restrictions associated with REITs or MLPs. This allows you to realize the benefits of having them in your portfolio without feeling locked in.

At What Point Can Bonds Make Sense?

 There are a couple scenarios where holding a portion of your portfolio in bonds can make sense.

Psychology

If you’re the kind of person that just can’t stand the large swings in price that often comes with stocks and index funds, then bonds are probably a better fit. In your case it might make sense to hold as much as 30 – 50% of your portfolio in bonds. This is a far less efficient way of growing your wealth. That said, efficiency doesn’t matter if you’re the kind of person that’s quick to sell on a market downturn.

If owning bonds provide the mental buffer needed to hold your investing course, then by all means incorporate them. Just realize that you’re paying a potentially high price for a bit of certainty. In an article written over 35 years ago, Warren Buffett summed this up nicely.

“A second argument is made that there are just too many question marks about the near future; wouldn’t it be better to wait until things clear up a bit? You know the prose: “Maintain buying reserves until current uncertainties are resolved,” etc. Before reaching for that crutch, face up to two unpleasant facts: The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.”

The future is never clear; you pay a very high price in the stock market for a cheery consensus.

Although Buffett was primarily discussing waiting for the market to be in a rosy position before investing, the same lesson applies to the way most people approach bond investing. Making an investment decision based primarily around obtaining a measure of certainty can be very expensive.

You’re Already Rich

 Say you’ve already made your money and are no longer in the wealth accumulation phase.  In this scenario all you might care about is a steady monthly check to pay your expenses. While I would probably still opt for a REIT or index fund that pays monthly, bonds might be the right thing for you.

You’ll pay more in taxes than if you received this income as a qualified dividend payment. But if you’re already wealthy, you probably don’t care. Money only matters as much as our need for it. The more you have available, the less you tend to worry about it.  I can see how the hassle-free way of obtaining income that bonds provide could be very attractive.

You Believe in A Stock Market Doomsday

 This one is along the lines of the earlier point on investor psychology.

Holding bonds could be a good idea if the world equities market were to see a downturn worse than the 2008 financial crisis. While this is extremely unlikely to happen, it would be foolish to say it’s impossible. The portion of your portfolio that’s held in bonds could weather the storm better than equities.

I’m not a big fan of this one because you’re making your investment decision based on fear instead of rational decision-making. To each his or her own.

Tying it Together

 My intention with this post was not convince you that owning bonds is silly. I simply wanted to point out that there are other great alternatives for obtaining steady income while taking on less risk. I’m all about efficiency and risk-adjusted returns in my approach to investing.

For me REITs and MLPs provide much more upside over bonds without a substantial increase in risk. That’s me though. Investing is very personal so doing what allows you to sleep well at night is important. An efficient portfolio doesn’t make sense if it gives your nightmares during market corrections.

One of the most important aspects of investing is managing your psychology. If bonds are a tool that allow you to do that, then you should definitely make use of them. As long as you invest consistently and always look for ways to increase your savings and investing rate, you’ll do fine over time.

What are your thoughts? Do you think I’m crazy for not holding a portion of my portfolio in bonds? How do you invest and why? Let me know in the comments below!

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