THE IMPORTANCE OF BONDS IN A PORTFOLIO
By Charles Rotblut, CFA, AAII
Had my weekly newsletter gone out on Wednesday instead of Thursday, it would have opened with a summary of a conversation I recently had with an AAII member about bonds and interest rates. This morning, after reading Warren Buffett’s arguments against bonds on Fortune’s website, I felt the need to revise the first few paragraphs to incorporate the Berkshire Hathaway’s (BRK.B) CEO’s opinions.
Buffett argued that bonds fail to protect investors’ purchasing power. He calculates that when taxes and inflation are subtracted from bond returns, investors fail to gain wealth. Given declines in the value of the U.S. dollar, bonds have ultimately hurt investors’ purchasing power. (Purchasing power is a measure of how much goods an amount of currency buys. As the cost of goods and services rises, purchasing power is diminished if wealth is not increased at an even faster pace. In non-economic terms, a dollar ain’t what it used to be.)
Buffett is right. If you hold your entire portfolio in cash or bonds, you run the risk of losing out to inflation. This is particularly a threat in today’s low-interest-rate environment. Worse yet, as I explained to the AAII member who recently called, there aren’t any fixed-income investments that don’t expose you to low yields, potentially falling bond prices in the future, credit risk or currency risk. Any option in the bond market right now has identifiable faults.
Still, I explained to the AAII member that I don’t think bonds should be eschewed. When held to maturity, bonds provide return of capital. Bonds also have low long-term correlations with stocks, making them a good diversifier. Plus, to the extent that the Federal Reserve’s economic forecast is correct, interest rates should not move much over the next few years.
The obvious downside is that interest rates could move higher sooner rather than later, hurting bond prices. Even a reversion to the historical average rates would adversely impact bond prices. This is not a problem if you hold a bond to maturity (unless you recently bought a newly issued long-term bond), but it will adversely impact bond fund prices.
Another downside, of course, is the low yields. We remain in a lousy environment for savers, with yields on the benchmark 10-year Treasury hovering just above 2%. Higher yields are attainable by investing in lower-credit-quality bonds and foreign bonds, but as yields rise, so do the risks.
The way around the current problems is to diversify your fixed-income holdings. Treasury, corporate, municipal, high-yield and foreign bonds (and bond funds) can all play a role in your portfolio. If you are willing to buy individual bonds, you can also build a ladder with bonds of differing maturities to offset future interest rate risk. Granted, this is far from a perfect solution, but given the prevailing interest rate environment, it is less risky than trying to predict unknown outcomes.
Keep in mind that bonds should only comprise one part of your portfolio. You still need to invest with a focus on price appreciation if you want returns high enough to preserve your purchasing power. Dividend-paying stocks, preferred stocks, real estate investment trusts and master limited partnerships can all give you capital gains and enhance your portfolio’s income. Just make sure you understand the characteristics and risk of any investment before you add it to your portfolio.
Finally, realize that even in the current low interest rate environment, short-term, low-yield bonds offer the advantage of liquidity and little downside risk, allowing them to potentially play an important role in your portfolio.
Buffett on Gold
Buffett also criticized gold as an investment, saying that it has “two significant shortcomings, being neither of much use nor procreative.”
I’ve personally never bought gold as an investment because I cannot value it. Gold has no cash flows; it is only worth the value that people are assigning to it at a point in time. Like other commodities, it does provide diversification to a portfolio, but beyond that, an investment in gold assumes that someone will think the precious metal is more valuable in the future than what you paid for it.
Charles Rotblut, CFA is a Vice President with the American Association of Individual Investors and editor of theAAII Journal.
Charles Rotblut
Charles Rotblut, CFA, is a vice president of the American Association of Individual Investors. He is the editor of the AAII Journal. He authors the weekly AAII Investor Update e-newsletter and his commentary is published on both Seeking Alpha and Forbes.com.
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I’m not a long-term speculator but this advice seems like it’s straight out of a seventies book on what people like to refer to as “investing”. Diversify your stocks, diversify your bonds, throw in some real estate, maybe some precious metals, a mutual fund or two maybe… What average person can construct a portfolio like that? Just assume the case that you are young, finally paid of all your debts and can now you can put away 800$ a month. What do you do? Buy 5 shares of stock, one bond and a quarter of a gold coin and 10 square inch of real estate?
Question for Larry fink and Buffet ” the tax
Why are you two encouraging investors to do the very thing which would guarantee stock prices to peak and go down?
Should companies be forced to offer higher rates on debt issued….how would that help stock ? what is the total return of the SPX since 2000 and the 10 yr Tsy?
And no Buffet the warning label doesn’t go on the security which for 30 years has achieved the returns that stocks were supposed to. The warning label goes on the asset class which has since 2000 went down 50% up 100% down 50% up 100%.
Don’t get it twisted.
Good article Charles. I particularly approved the focus on the difference between investing in specific bonds and the risks if you invest via a fund. Clearly the latter spreads risk ,but makes your risk part of general risk response which undermines the advantage of holding until maturity.
Should also point out that in shorter maturities there is little volatility outside of the ‘broken’ business model issues. This is because everyone knows that with maturity approaching the price will be heading back to par leaving little price opportunity.These offer on occasion very good places to park surplus cash when you don’t want to be invested for growth etc.
Price protection on longer maturities can be had by finding an allocation balance between those holdings and something that is linked to growth,that is Infaltion linked issues ,or a sector like Bio tech ,or an emerging market equity holding.Depending on one’s age ,but for us older one’s a mix of bonds balanced with the former for protection of purchasing power is ideal.
Mr Buffett has my respect ,but we should also recognise his strategy is difficult for people to begin to replicate the older they get because most cannot afford to be sat on 40% plus drawdwon on capital at a time they need an annuity and many at that age simply do not have a cash cow available every year to buy such drawdowns which is what Buffet does.He is a special case and actually I’l like him to qualify his advice ,or stop giving it out like it is a magic potion when it really does not apply generically to everybody.
100% agree with you on Buffet. Listening to him can be very dangerous. I know quite a few people who fancy themselves Buffet style value investors – I especially dislike the term investor when in fact they are just buying stock from someone else, changing nothing for the company they now own a tiny part of. Most don’t have the capital and leverage (who has?) and staying power Buffet has. Even if you find good value opportunities you need to be able to unlock that value. How could you do that by owning a few thousand shares? It’s Buy and Hope and that’s exactly what the smart ones on Wall Street want the retail people to do so they have a constant influx of liquidity.
As an addendum ,the more you are ‘real’ money and have more than expenditure requires the better psotion you have to buy bonds for maturity wherby one simply sits and let’s the market do whatever it wishes to do. If you have managed to buy a panic bailout of bonds yielding 10% + to maturity and you know you never need to realsie the capital you can just draw the income and ignore the market noise because frankly it has no relevance to you. When I see the market noise and squabble week in week out and all of the emotional furor it reminds me what a good position that is to have.
That bonds in the current environment will fail to protect against inflation is almost a sure bet, but that fact does not prove that stocks will protect against inflation. All we know about stocks is that historically dividends have gone up at around 6% per annum, while stocks can return a total return of zero or negative over long periods of time(and have grossly underperformed over the previous twelve years). Bonds by definition, if held to maturity have a capped return and downside risk equal to the total investment, but that doesn’t take away from their ability to lower portfolio risk.
The bond question could have been better phrased if it asked at what interest rate, does the duration risk outweigh the marginal basis paid over cash; To put it another way, to lock money away for ten years at 1%, might I not prefer to keep the money in a safe deposit box, keep the liquidity option and have the ability to put my money to use when the environment presents better values?
Why don’t people get this? How are you promised inflation protection with stocks?
If earnings aren’t there, dividends go away and you can lose principal. With a bond, you know what you’re getting (at least with treasuries), even in a deflationary environment. People seem to think that stocks must go up. How long after 1929 did it take for stocks to recover to their post-crash level? How long have things been dismal in Japan?
Starting from where we are currently I for one am more than happy to have some allocation which works to the golden compounding rule 10%pa ,7 years, double your money. I cannot see the future and I know no one who can ,but I do know that if I can work to that rule inflation can do what it wants because if I am hurting nearly everyone else will be ruined in which case i will still be the richest guy in a very poor crowd.
author is looking at the wrong bonds: residential ARMs issued in 2003-04 at to Prime/Alt-A borrowers at reasonable LTVs can be had at deep discounts to par, resulting in base-case yields in the 4-5%’s. If rates rise, these would improve in price as higher rates would be predicated on better housing fundamentals (not to mention the coupon reset higher).
There is your yield without interest rate risk.
jswede, don’t take this the wrong way, but i used to run an ARM fund, and they are lousy investments from a total return standpoint. They all have periodic caps and lifetime caps, there is little potential for capital gains, and ALT-A paper is a synonym for “sub-prime” garbage. In addition, a round lot is $1mm, oh, and they are fully taxable.
If you like mortgage backeds, buy Jeff Gundlachs fund(DBLTX), otherwise, IMHO steer clear of MBS, it’s not for amateurs.
A much easier way to buy bonds is to look at what sector is out of favor. Recently, junk, bank preferred’s and emerging market debt were on sale. A while back, muni’s were being given away. If you’re patient, there are bargains in all sorts of bonds – and that occasionally includes Treasuries.
I’m guessing you are talking GSE-backed RMBS.
I’d agree that ARMs are (usually) – by definition – a lousy total return product. they, in theory, reset the coupon annually so that the price stays at par. your total return is then the coupon income, only.
however, the non-agency backed RMBS I speak of are not priced at par, they are at significant discount to par, due to the stigma of the sector. As you say, “look at what is out of favor”.
“garbage”, subprime or otherwise, has everything to do with the price. what some call garbage at par, may be the safest investment you could buy at 50 cents.
Regarding Gundlach – this RMBS strategy is in large part what he uses in his DBLTX, and is in most part why he’s done so well since he started DoubleLine.