Bonds go slow but steady

A fabulously articulate and doubtless physically attractive Monevator reader (yes, I’m a fan of all our readers!) emailed to ask why invest in bonds, given the superior returns from shares.

He spoke thus:

It’s financial orthodoxy that bonds should form part of everyone’s portfolio. Equations abound, such as “hold a percentage of bonds equal to 100 minus your age”.

I do understand that bonds are crucial for people forced to live off income, such as retirees.

However the other reason frequently given for holding bonds is to ‘reduce volatility’.

I’ve always failed to understand the logic of this argument. As long as you have a long investment horizon, then volatility should not affect your investment. Prices rise and fall, and the value of portfolios do likewise.

As long as there is no need to sell, however, then it makes no difference.

Given that equities have historically outperformed bonds, I wonder why anyone in their 20s or 30s would hold any bonds whatsoever?

Or am I missing something?

This blog has the smartest readers. You guys ask all the right questions.

I can’t reply in detail to the many emails we get each week – and I can’t give personal advice at all – but it’s always great to hear from you. As also shown in your comments on the site, you’re an above averagely clever cohort. (Heck, we even know what “cohort” means around here. Go us!)

Onto this query, which I’ve heard quite a lot recently, especially with the rise of Vanguard’s automatically rebalancing LifeStrategy equity/bond funds.

I should first say that asking me why invest in bonds is a bit like asking Worzel Gummidge why shower. I’m skeptical about corporate bonds, and while I do think government bonds have a role to play for most people, I usually hold none myself.

I do understand though why nearly all model portfolios include a slug of government bonds. So hopefully I can give a rounded answer without spouting too much ‘financial orthodoxy’, as our reader puts it.

Below are seven reasons why bonds – UK government bonds – might earn a place in a portfolio, despite the superior prospects of a 100% equity portfolio.

Note that I’m not debating here whether bonds look good or bad value right now. We’ve covered that elsewhere. (Executive summary: They look expensive to me).

Government bonds are the safest asset class after cash

Ignore the ranting of the lunatic fringe1 – for the UK investor, UK government bonds (aka gilts) are the closest thing to a risk-free asset class, after cash.

Safe here means “return of capital” not “return on capital”.

Since 1950, UK bonds have delivered an after-inflation return of 2%, versus about 7% for UK equities.2 2% is not a huge margin of safety. If inflation is higher than expected, the real return from bonds could be closer to zero, or even negative.

But no investment is entirely risk free, and inflation aside, gilts are safe.

There is a near-zero chance of the UK not honoring its bond commitments, because it can print the money to do so. When you buy gilts, therefore, you can be extremely confident of the return you’ll get from the interest paid plus the return of capital. That’s attractive compared to the uncertainty of every other asset class.

You can even sidestep the inflation risk if you buy index-linked government bonds or TIPS in the US. (Like other government bonds, they’re currently priced for very little return though).

Volatility can be scarier than you think

Most people believe they can cope with volatility. However when confronted with their net worth plunging 5% in a day, 20% in a month, or 50% in a decade, they often change their tune.

The speed with which a bear market can slash the value of shares is proof positive that many investors panic when times turn tough – because their dumping of shares is exactly what drives the prices down.

Government bonds tend to go up – or at least better hold their value – when share prices fall. They also pay an income. Both factors curb the decline in your portfolio’s value when shares plunge. This silver lining can make stock market falls less terrifying. There’s nothing irrational about wanting some security.

By all means steel yourself to ride out volatility. That’s what I do. It’s easier if you’re young, and much easier if you’ve got substantial new money coming in from savings.

But you won’t know for sure how you’ll cope with extreme market falls until you’ve lived through them. Even after that, you might react differently at 60 when most of your lifetime savings are at risk, compared to how you did at 30.

Most people are much more risk-averse than they think. Why be a hero?

Diversification with a slug of bonds is cheap and effective

If shares do better than bonds – and they always have in the UK market over two decades or more – then a 100% equity portfolio will beat the returns of a portfolio that includes bonds alongside shares.

However adding in even a small allocation of bonds can reduce the maximum losses you’ll suffer in a bad year without significantly decreasing your overall return.

Without getting bogged down in financial theory, it’s all about the ‘efficient frontier’, which is the point where diversification is actually reducing risk while maintaining returns.

The following graph shows how portfolio theory suggests risk (volatility) and return will change as you shift your allocation between equities and bonds.

Diversification is the only free lunch in investing, and bonds are on the menu.

Diversification is the only free lunch in investing, and bonds are on the menu.

Of course, you can’t eat theory. What about real world results?

Well, you can use different time periods to make pretty much any point in investing. However this example data covering a 20-year period in the US markets between 1988 and 2008 is pretty typical:

  • A 100% US equity portfolio returned on average 11.59% a year over the 20 years. The worst year saw a decline of 20.25%.
  • A portfolio with a 55% allocation to bonds and the rest in shares returned on average 9.95% a year. It fell a mere 3.35% in the worst year.

Many people would have lost sleep and hair enduring the 20% decline in the all-equity portfolio, even if they managed to stay invested.

In contrast, I think even the flightiest saver could stomach the minus 3% worst-case year of the bond heavy portfolio.

Yet despite the massive allocation of bonds required to produce that low downside risk, the ultimate price paid – the reduction in return – was less than 2% per year. Painful when compounded for sure, but not fatal.

Now, get pinching your salt. This particular 20-year period saw a boom for bonds. Their returns were unusually high, due to a collapse in yields that cannot be repeated.

But we only know this from hindsight. Also, if your shares do much better than bonds in the future, then you probably won’t care too much, as long as you’re not too bond heavy. Even the worst case for bonds – a full-on bond market crash – will likely be milder than a stock market crash.

For the avoidance of doubt, I’m not advocating a 55% allocation to bonds. This is just example data; personally I’d lean to less is more. Check out these model passive portfolios for some expert ideas on asset allocation.

But remember, sensible investing is not about aiming for the maximum return that’s possible over the period you happen to be invested. That’s the siren call of City promoters. It’s the thinking that got people loading up on tech shares in 1999, and giving up in the depths of 2008.

Your aim when investing is to devise a strategy that works for you, and that you can stick with.

Lower than maximum returns is a price worth paying if it keeps you happily investing for your lifetime.

The outperformance of shares in the past may not continue

This brings us to returns, and the implicit assumption that shares will always do much better than bonds over the long-term.

In the UK and US that’s been true. But a look at the long-term returns from other stock markets around the world shows the degree of outperformance of shares over bonds has varied, even over the extremely long-term.

Over the short to medium term, anything can happen.

Japanese investors in the Tokyo stock market – who are still down 75% from the Nikkei’s peak of the late 1980s – might offer an especially salty rebuttal to anyone urging an all-equity portfolio.

There are strong theoretical reasons why shares should do better than bonds (it’s all about risk and reward). And I’m literally betting my own asset allocation on it, with bonds seeming to me to be at the end of a bull market and the returns of the past three decades mathematically unrepeatable from here.

But there are no guarantees.

A holding of bonds enables you to rebalance effectively

We know from Warren Buffett that we should “be greedy when others are fearful” when faced with bombed-out stock markets.

But where are you meant to get the cash to go on a buying spree?

Buffett himself urges investors to stay invested in great companies through thick and thin.

Sage advice no doubt, but if you’re 100% invested in shares when the market crashes, you’ll have to limit your being greedy to going to pizza joints in the City to scoff at worried bankers.

In contrast, if you’ve got a slug of bonds you can sell them down to stock up on cheap shares, either haphazardly or through a more formal rebalancing strategy.

As you age, you’ve less time to recover from crashes

Like many things, the answer to our reader’s query is in his question. He says we’re assuming a long-term horizon, but the fact is not everyone has that – and none of us have an infinite one.

As mentioned, the Japanese market peaked in 1989. Even the FTSE 100′s peak was 13 long years ago. If you were 60 in 1999 and you were 100% invested in shares, you took a big gamble.

Focusing on income can offset some of the risk of volatile share prices. Dividends are much less variable, and the UK’s best income investment trusts have not cut their payouts in the bad times, while handily beating inflation over the long-term. A high yield portfolio might deliver something similar for a DIY stock picker.

Reinvesting dividends while you’re saving improves the picture, too.

But I still believe that a 100% equity portfolio is a young man or woman’s game, given how long a crash could endure. As we age, we should take less risk when investing, not because our heart can’t take it but because our time horizon can’t.

(Our questioner acknowledges this. Again, the answer is in the question!)

Finally, I never want to be a forced seller of shares

In the US, where dividend yields are lower, it’s normal to plan to run down a share portfolio by selling some proportion each year to create an income.

Indeed, the various studies you’ll see on the 4% withdrawal rule are based on this. So it’s not true that even a pensioner needs an income from bonds – theoretically they could sell their shares for spending money instead.

However I’d hope to live off the income from my portfolio in retirement, rather than actively selling – again because capital values are far more volatile than dividends.

The last thing I’d want to be doing if I was 75-years old would be to flog my marked-down equities in a bear market just to pay the heating bill / Majestic Wine tab / chorus girls.

I fully expect that at 75 I’ll have a slug of bonds as part of a diversified income portfolio. This should give me a good shot at living off my investment income, without having to touch my capital unless I choose to.

The bottom line on investing in bonds

While holding some percentage of bonds relative to your age might be a good rule of thumb, there’s no law that says you have to.

Also, I think private investors (as opposed to institutions) can often substitute cash in high interest deposit accounts for at least some of our bond holdings. While cash and bonds are not the same, cash will do a similar job in cushioning your portfolio. (Given where bonds are currently, this is the approach I’m taking).

I think a 100% equity portfolio can make sense for some, especially when you’re young or your portfolio is relatively small compared to your other assets or your potential lifetime savings.

But bonds are an important asset class, and they’re not to be lightly dismissed in pursuit of an extra percent or two of annual return.

The times when a decent allocation of bonds (or cash) will prove its worth are the dark times when you could be very glad you kept them in the mix.

  1. I am thinking of those bloggers and others who think the UK national debt is so large that we are at risk of default
  2. Source: Credit Suisse Global Investment Returns Yearbook 2013

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