Bonds have gotten a bad rap, not necessarily for bad reason with interest rates probably rising. Here though is why you may still want bonds, but it might not be what you think.
Barron’s Beverly Goodman wrote an editorial in last week’s edition saying that she has no bonds whatsoever. I get what she’s saying, but my concern is that for a lot of people, this is going to end up being bad advice for people who 1) don’t understand the nuances of what she is doing, 2) don’t have her exact financial situation, yet are applying her portfolio style as if it was a cookie cutter, and 3) may very well be better off with a certain allocation to bonds.
One (bad) argument for bonds
One argument for bonds that I do NOT like is that bonds pay income, and “some investors need income.” This is outdated thinking. Institutions for decades have thrown away categorizing money as “principal” and “income” and realize that money is money. You need a total return approach, instead of arbitrarily putting capital gains and income into two different buckets. If you get 3% from your asset going up, or by the asset paying 3%, does it matter?
Institutions have gotten over this fallacy long ago, but individuals have still held on to it. Frankly, it’s even worse for individuals to buy into this fallacy, since income is generally taxed at a higher rate than capital gains, whereas institutions may be tax-exempt if they’re a foundation or endowment.
Why you may want bonds
One reason, if you follow a modern portfolio theory plan, is that bonds are pretty much the only asset class that historically has negative correlation to equities. We’re at market highs on the Nasdaq right now, right after the Chinese government literally shut down portions of their market to stop the selloff over there. I’m a little leery of what will happen when those stocks get un-frozen. I’m also leery by nature whenever “all time high” is a headline in the news. I’m not sold that going completely all-in on equities is the right path in this environment.
Do I have criticisms of modern portfolio theory? Absolutely. That said, it’s a plan that can avoid getting a lot of people in trouble. Yes, perhaps you could be more tactical and rotate in and out of stocks and bonds depending on the market, but for the vast majority of investors (not just retail, but plenty of professionals that I’ve seen), this will get them in nothing but trouble. They will go all in on stocks at the top of bubbles, and they’d go all into bonds at market bottoms. If you don’t believe people behave like this, ask anyone who has worked as a financial advisor for more than 6 months about investor behavior. Having a set allocation and staying with it can keep people from blowing up—and, over enough time, most likely get them to an acceptable rate of return for their goals.
Secondly, it’s actually pretty hard to lose money in bonds if you do it right. A bond with a 3% YTM may fluctuate if prevailing market rates at that tenor shift, but if you hold that bond to maturity—you’re still getting a positive 3%. Moreover, if you have a properly diversified bond portfolio, securities are continuously paying coupons and coming to maturity, and that capital will be re-invested into the higher rates as rates rise.
I’m making an assumption with that last point that you’re not an idiot and dumping your entire fixed income allocation into 30-year Treasuries. The key word is proper diversification.
Finally, there are opportunities in municipal bonds for high tax-rate investors. As of July 17, 2015, according to Yahoo Finance:
- 10 Year Treasuries were yielding 2.35%
- 10 Year AAA Corporates were yielding 3.09%, and AA were yielding 3.36%
- 10 Year AAA Munis were yielding 2.28%, and AA were yielding 2.47%.
At a 40% tax rate, AAA munis have a 3.80% tax equivalent yield, and AA have a 4.12% tax equivalent yield—both superior to Treasuries and AAA/AA corporates.
Other weapons in the arsenal
Beyond munis, investors have other debt securities that they can use, such as:
- Floating rate securities, some of which are packaged in ETFs
- Opportunistic distressed debt
- Convertible securities—be aware though that these can have high equity correlations
- Non-traditional/absolute return debt managers
- Fund managers who have endured rising rate environments before, such as 1993-1994, 1998-2000, and 2003-2006
Believe it or not, but this wouldn’t be the first time in human history that interest rates have gone up. I’d look and see at which fund managers did well during those periods in the past.
Saying bonds are “good” or “bad” is too simplistic of an argument. A lot of financial journalism, or journalism in general for that matter, needs to sell subscriptions or clickbait clicks, so arguments have to be reduced to “LOLOLOL DURR BONDS ARE GONNA FALL.”
If you can’t handle a nuanced point that bonds aren’t just “good” or “bad” and it depends entirely on 1) what the investor’s objectives are, and 2) what specific bond strategies are being proposed, then you probably shouldn’t be investing, or at the very least, you shouldn’t be investing money on behalf of clients. That, or I have some ocean-front property in Dallas that I want to sell you.
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