What’s All the Fuss About Bonds Being a Lousy Investment?

March 07, 2014

Every time I’ve talked with someone about their investment portfolio recently, the subject of owning bonds or bond funds has inevitably come up. Most of the time, the conversations about the fixed income (bond) portion of their accounts has been less than hopeful. And the cynicism/pessimism hasn’t been coming from me…

I have heard from dozens of people that they are afraid to take money out of the stock market since the returns have been so great and we are near all time highs, especially if that money is moving into cash or bonds that have had relatively low rates for the last several years. Bond funds in 401(k)s seem to have a particularly bad reputation right now. Last year, the Barclay’s US Bond Index was down 2% while the S&P 500 was up 32%.

In the face of that recent history, the average investor would run from bonds and jump toward stocks. But what is that old saying about how to make money investing….“Buy low, sell high”? Jumping into stocks at their current high is viewed as less risky than moving money into bonds that have underperformed lately. Add in that nearly everyone involved in the financial world expects rates to rise, which means that bond prices will fall, and you have a recipe for people to avoid bonds.

But let’s take a look at some reasons why you might not want to avoid them.

Even if rates rise and bond prices fall, that isn’t the only component of bond returns. Bonds pay interest. So, if they pay a 4% annual interest rate and prices fall by 2%, there’s still a 2% total return on the positive side. The interest that bonds pay really buffers losses.
Bond prices don’t fall in epic fashion like the stock market does. We’ve all seen various stock index returns at -20% to -30% or more. It is incredibly rare for bond funds to lose as much as 10%.
We have been in a 30+ year cycle of declining interest rates. Since the late Jimmy Carter/early Ronald Reagan era, we have seen rates in decline. If rates rise, they likely won’t go from where they are today to the mid-teens overnight. There will be a slow increase of rates, barring the very unexpected.
I’m guessing that if I’ve got that figured out, the folks who actually manage bond funds have it figured out too. And guess what? They do! They are managing their portfolios with shorter term bonds so that when they mature, they have cash freed up to buy higher interest rate bonds.
Bonds are a part of a balanced portfolio. Asset allocation is a great tool for risk management. If we experience another 2008ish scenario, where the S&P drops 30-40%, anyone who has money in bond funds will not be incredibly sad that their portfolio isn’t 100% invested in the stock market.
I know that rates for cash and bonds right now aren’t exactly spectacular. And if you owned bond funds in 2013 you were disappointed in the returns. Are you willing to count on the stock market producing double digit returns again year after year? Or are you more concerned that the market is near all-time highs in the face of an economy that hasn’t been exactly stellar for the last 6-7 years? Bonds, while rarely producing a 10% annual return, even more rarely see values fall substantially. They offer more of a tortoise approach than the hare of the stock market. Based on your goals, your individual ability to withstand investment risk, now could be a great time to consider reviewing your investment risk tolerance and the percentage of stocks vs. bonds vs. cash that might be appropriate for you.

While you are considering how to invest your retirement funds, you may be doing some research and listening to the opinions of “experts.” Many experts now are warning about the dangers of bond funds. Consider that experts aren’t always clairvoyant and that now may be an opportune time to review your overall asset allocation and maybe even to consider adding bonds (or bond funds) to your portfolio as a means of reducing your overall investment risk.