Yes, Bonds Are a Lousy Investment Right Now

March 27, 2014

A couple of weeks ago, my colleague Michael Smith, wrote a blog post defending bonds called “What’s All the Fuss About Bonds Being a Lousy Investment?” With all due respect, I do think bonds are a lousy investment right now. Let’s take a look at each of Michael’s points as to why you shouldn’t avoid them:

“Even if rates rise and bond prices fall, that isn’t the only component of bond returns.” It’s true that bond interest can help cushion the blow from falling principal values but that cushion was a lot larger when interest rates were double digits or even 6% than when they’re only at 2-3%. In other words, it wouldn’t take very much loss of principal to wipe out all of your interest returns.

‘Bond prices don’t fall in epic fashion like the stock market does.” Yeah but they still fall in value and they don’t rise much either, especially when rates are already as low as they are and can’t fall much further. (Interest rates and bond values move in opposite direction. For example, the average bond fund lost 4.6% when the Fed raised interest rates in 1994.)

“We have been in a 30+ year cycle of declining interest rates. “ That means historical bond returns were based on a period when interest rates were high and falling, which boosted bond prices. Guess what 30-yr cycle we might be in now?

“I’m guessing that if I’ve got that figured out, the folks who actually manage bond funds have it figured out too.” Just like tech fund managers figured it out before the dot com bubble crash and real estate fund managers figured it out before the real estate crash? Keep in mind that most fund managers measure themselves based on relative performance compared to other managers of the same type of fund so if most bond funds lose 10% and you lose 8%, you win. The only problem is that relative performance won’t fund your financial goals.

‘Bonds are a part of a balanced portfolio.” That’s the best argument in favor of bonds. They move differently than stocks and can reduce a portfolio’s overall volatility. On the other hand, you can get much of the same effect without the risk of rising rates. One option in many retirement plans is a stable value fund, which pays interest like a bond fund but with insurance that protects against volatility. Another option is a floating rate fund, which can adjust upwards with rising interest rates. With peer-to-peer lending sites like Lending Club and Prosper, you can loan directly to other individuals and get much higher interest rates (and possibly higher default risk so be sure to diversify). Finally, there’s always cash, which isn’t paying all that much less than bonds (and sometimes more) but without the risk.

“Are you willing to count on the stock market producing double digit returns again year after year?” No but I am willing to count on stocks delivering higher long term returns than bonds as they have always done. This will probably be especially true going forward given the low interest rates today.

For these reasons, I don’t invest in bonds (except for some bonds in a couple of my mutual funds that are expected by the fund managers to have “equity-like returns”). That being said, you can certainly still decide to keep bonds in your portfolio as part of your overall allocation. Just don’t put all of your eggs in that basket thinking that it’s safe.