Bonds may be perceived as boring, but their stability and liquidity help owners sleep well at night. While there have been periods when bonds offered both attractive returns and less volatility than stocks, their yields today are close to all time lows. Despite this, they continue to play a vital role in investment management.
At the start of my career in August 1982, a ten-year note issued in U.S. Dollars and backed by the full faith and credit of the U.S. Government paid investors 12.6% annually. Inflation was 6.2%, so it seemed likely that the principal paid at maturity would retain most of its value. You could put money in an asset that was both safe and provided a return over inflation.
Today, the ten-year U.S. Treasury note pays only 1.3% interest. If the Federal Reserve succeeds in steering the economy to generate an average inflation rate of 2%, the principal repaid at maturity may be worth less than it is today. If interested in how yields have changed over time, visit the U.S. Department of Treasury’s website.
Why it makes sense to continue to own high-quality bonds
It is fair to question the use of fixed income at the current meager interest rates. Why not just invest in the stock market where there is a possibility of a greater return? The answer is that good investing requires blending high-risk and low-risk investments to achieve a level that is appropriate for your goals. The right risk level is seldom 100% U.S. Treasury securities or 100% stocks.
Beautiful, boring bonds to sleep well at night
I remember well a young colleague asking me, back in the summer of 1999, why anyone would buy bonds. It was a period when stocks had enjoyed four and a half years of great returns. Many young investment professionals had never experienced a major stock market drop. To them, bonds offering 6% interest for the next ten years made no sense. A cumulative 38% drop in the U.S. stock market over the next three years reminded investors of the beauty of boring bonds.
Bonds are contracts between a lender (the investor) and a borrower, committing the latter to pay the investor interest over a specified period of time. If the borrower fulfills their commitment, the investor receives a total return (called the yield to maturity) which is calculated based on the bond’s purchase price. Certainty of return over a period of time has value.
Bonds are exposed to the risk that the borrower will not have enough cash at maturity to repay bondholders. The more uncertain the borrower’s ability to repay, the higher the interest rate required to entice investors to lend them money. For more on yield and total return, read our blog Income-Oriented Versus Total Return Strategy.
Published credit ratings of bonds provide an estimate of the possibility issuers may default on their commitment. Even when there is a default, bondholders often receive some of the principal amount they are due. They always receive a higher percentage of the remaining assets compared to stockholders, who are only entitled to whatever assets remain after bondholders are paid.
Bond issuers are more varied than companies issuing stock to the public. There are bonds from:
- most governments in the world,
- municipalities in the U.S.,
- banks, and
Those with the highest credit ratings are highly likely to repay the entire principal of the bond at maturity. Bonds enable investors to sleep better when the rest of their investments are fluctuating daily in value.
The benefit of bond funds rather than individual bonds
Whether an investor owns bonds directly or through a fund, the risk exposures are the same, but a fund benefits from diversification, liquidity, and lower trading costs. Individual bonds trade in large lots for a million dollars per taxable bond and a hundred thousand per municipal. Large bond funds offer a more diversified portfolio of borrowers and maturities, and have access to better research. In addition, bond funds provide greater liquidity than trying to sell a small position in an individual bond. For a more detailed discussion on the benefits of bond funds, please see one of our previous articles, The Rationale for Bond Funds.
Low risk, high return investments do not exist
When my kids were growing up, we enjoyed the book “Where’s Waldo?” , searching for Waldo with his red and white striped shirt and hat among crowds of people on each page. He was always there, but finding him was seldom easy. Investing has a parallel activity, “Where’s the Risk?” If an investment is promoted as providing a return above U.S. Treasury securities, it has risk. It may be as hard to find as Waldo in a crowd, but it is there. There are no low-risk and high-return investments.
- High dividend-paying stocks look very attractive compared to bonds. Coca Cola stock’s dividend yield is 3%, while its recently issued ten-year bond yields 1.7%. The stock’s dividend is tempting, but the risk is the uncertainty of the stock’s price in the future.
- Real estate, art, and collectibles prices seem to be less volatile. While some will likely retain value, particularly in an inflationary environment, their lack of volatility is simply due to infrequent measurement. Their values are fluctuating as much as other assets with comparable risks. Risk cannot be eliminated by not measuring it.
- Bonds offering high yields may introduce currency risk. For example, Mexican Government bonds are yielding 6.9%. Their total return to a U.S.-based investor will depend on the future exchange rate of the Mexican peso.
Any of the above may be a sensible part of a diversified portfolio, but none have the same role as high-quality bonds. When a sales pitch offers “stock-like returns with bond-like volatility,” be skeptical. For stock-like returns, there are stock-like risks to be found. Bond risks are easier to assess, so they provide greater peace of mind.
Mattresses are not safe
In June of 2009, as economies started to recover from the Great Recession, a young woman bought a new mattress for her mother. She wanted the gift to be a surprise. She arranged for the delivery while her mother was out and had the delivery guys take the old mattress to the dump.
When her mother came home, the daughter was shocked to learn that she had just thrown out their life savings of a million dollars – cash which her mom kept hidden in her old mattress. Here is the original CNN World article.
While cash at banks and in mattresses today earn no return, the risks are different.
Investing well requires understanding all the risks and choosing those that provide an appropriate return for the risks incurred. While today’s low-interest rates make the cost of safety high, use bonds to sleep well at night and hold them at a custodian rather than stuffing them in your mattress.
Feel free to email me at firstname.lastname@example.org with any comments or questions on bonds or on investment management in general.