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Independently Financed

Good reasons to own bonds

January 9, 2021 by indyfinance Leave a Comment

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For as long as I’ve been writing about money, I’ve been saying almost everybody owns too many bonds. My argument has nothing to do with “risk” or “volatility” or “rebalancing.” It’s much simpler than that: bonds don’t pay enough in interest. If and when they start paying more in interest, I will like them more and start saying people should buy them.

But for every traditional use of bonds in an investment allocation, you’re better off putting money into high-interest checking accounts or triggering new account sign-up bonuses. Federally insured deposits, guaranteed returns, and almost immediate access to your money are simply too valuable to give up without a good reason, and bonds haven’t been a good reason for years.

As a rule, the more firmly I believe something, the harder I hunt for reasons I might be wrong, so today I thought I’d share the best reasons I could come up with to own bonds.

Seeking more risks

This may strike you as slightly counter-intuitive, since most people are trained to see bonds as the “safer” element of their portfolio and stocks as the “riskier” portion, but it’s actually quite simple: it’s relatively difficult to find genuinely different assets to invest in. Take for example Vanguard’s US stock funds. You can buy the Total Stock Market Index Fund and get a market-capitalization-weighted exposure to the entire US stock market — a perfectly sensible thing to do, which is why I do it.

If you want to turn up the volatility on your portfolio you might instead buy the Vanguard 500, the Mid-Cap Index, and the Small-Cap Index and equally weight them. This would radically reduce your exposure to large-cap stocks (which make up the majority of the Total Stock Market Index) and turn up your exposure to medium and small companies. You might do this on the theory that small and medium companies are more volatile than large companies and therefore should offer higher returns over time.

The problem is, it barely makes the slightest difference. Since November, 2001, the total stock market returned 9.28% annualized and the equally-weighted portfolio (dividends reinvested, rebalanced annually) returned 9.94%. And nothing about that should surprise you! After all, both portfolios are investments in the success of the US publicly-traded corporate sector. Whether you look at an elephant through a magnifying glass or a telescope you’re going to see the same thing: an elephant.

The first thing investors do when seeking more risks is to look abroad. Just as in the US case, you can slice up “abroad” differently: developed world versus emerging markets, Europe versus Asia, or even country by country until you’ve filled up your menagerie with an elephant, a giraffe, and a rhino. Genuinely different critters. But you’re still looking at the success of the publicly-traded corporate sector. They’re still all mammals!

I think that’s fine. If you regularly invest in the global stock market for 30 years you’ll end up rich, which is the point of the activity, right? Have a cardiologist standing by and all that. But once you’ve met that threshold, I find the impulse to try to goose your returns even more perfectly understandable. The only individual bond fund I own, in fact, is Vanguard’s High-Yield Corporate fund. That’s because I’m not using it to try to stabilize my investment returns, I’m using it in the hopes of increasing my investment returns! You might use the Emerging Markets Government Bond fund (or the ETF share class to avoid the pesky purchase fee) for the same purpose.

What I want to make clear is that I’m not talking about “diversification” or “risk tolerance” or anything like that. I’m talking about seeking assets with the potential to generate higher, not lower, returns over time. You might be wrong — the bonds you buy might default, might be called early, might suffer from changes in exchange rates — but there’s nothing inherently irrational about trying.

Extreme Inflation Sensitivity

I personally don’t take inflation very seriously, and think most people take it more seriously than they should. But there are reasons for that. I don’t own a car, so fluctuations in the price of gas don’t affect me directly at all (of course they trickle through the supply chain so I pay more or less for cabbage depending on how much it costs to deliver it). My biggest expenses are things like rent and utilities, prices which are “sticky” either by contract (my rent is written down on my lease) or by law (utilities are highly regulated). For those paying off fixed-interest loans like mortgages or car notes, inflation is a boon, since workers may see it reflected in paychecks without suffering increases in those large monthly expenses.

But of course there are people who really are directly impacted by price inflation. Truck drivers who pay for their own gas may not be able to immediately pass along price increases to customers if they have long-term contracts. Chefs who buy meat or produce wholesale may be reluctant or unable to immediately pass along price increases to diners (the origin of so-called “menu costs“).

If that describes you, then you may well want to invest in assets that have built-in inflation insurance. High-interest checking accounts should (hopefully) eventually reflect inflation in higher interest rates, but assets like TIPS are guaranteed to.

Ease of Administration

One problem a lot of people run into is that their assets aren’t in the right “buckets” at the right time. For example, consider a $100,000 portfolio that consists of $70,000 in stocks and $30,000 in high-interest checking account deposits. After a 50% drop in stock prices, the investor wants to restore their original asset allocation by buying $10,500 in stocks. No problem, that’s what the cash is there for. But if the stocks are held entirely in an IRA, our investor has a problem: the 2021 IRA contribution limit is just $6,000, some of which may already have been used up through automatic contributions pre-crash (the 2020 stock market crash began in late February, for example). That means after a $6,000 IRA contribution, the additional $4,500 investment needs to be made in a separate taxable account, and can’t be sold and moved over to the IRA until the next contribution year begins.

One way of looking at this is as a tax nuisance, since the sale of the rump shares will be a taxable event, but I think that’s a pretty dumb perspective. US capital gains taxes just aren’t high enough for ordinary people to worry about, although there are corner cases where reporting capital gains can cause serious problems, like Earned Income Credit qualification.

My perspective isn’t that it’s a tax headache, but that it’s a headache-headache, and the more annoying it is to manage your finances, the less likely you are to do it properly. The advantage of target retirement date or target risk funds isn’t that the funds themselves offer better returns than the underlying investments, but rather that the ease of managing them increases the likelihood that you’ll manage them correctly. It obviously doesn’t completely eliminate the risk of mismanagement — I once talked to someone who “simplified” their asset allocation by splitting their investments equally between the S&P 500 and a target retirement date fund, which of course also owned the S&P 500!

So if having some cash or bonds in your IRA or 401(k) is what it takes to fit your investment responsibilities within your mental investment bandwidth, then you have my blessing.

Conclusion

What I’ve been trying to stress throughout this post is that my aversion to bonds is totally unprincipled. When the interest paid on investment grade bonds is low, and the interest paid on high-interest checking accounts is high, I keep my cash in high-interest checking accounts. If the interest rate on investment grade bonds ever rises above the interest rate paid on high-interest checking accounts, I’ll move the cash into bonds.

Let the economists argue about whether low interest rates are “structural” or “cyclical.” I couldn’t care less why they’re low, I care that they’re low.

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