Ask Dave: Why Bonds Anyways?

A reader asked me:

I am 29 and am basically just getting started in investing. Since I am young-ish I have decided to start with an 80/20 mix of stock/bond in my portfolio. I’m pretty sure I want to buy bonds, but don’t know which short term bonds to buy. However, looking at expected returns for bonds (3%-6%), should I really get them in the first place?

I want to have 20% of my total portfolio in bonds. Honestly I can not decide between XBB or XSB and honestly don’t know how to pick one over the other or is there a mix of bond indexes I should buy into? However, if E*Trade is telling me their Cash Optimizer Investment Account is going to give me 4.15% why the heck would I even buy bonds (which fluctuate and introduce risk) when I can get 4.15% GUARANTEED on my money? What is the incentive (or logic) to buy the bonds? I have heard that if E*Trade went bankrupt – I might lose the cash I had in the Cash Optimizer Investment Account (since it was not technically invested in anything that is insured – is that BS or what?) – where as if I owned the bond index – that is a protected insured investment. Perhaps that is a reason I should actually buy the bonds? Comments?

First of all let me give the simplest answer possible: Don’t put all your eggs in one basket. I see the bond and equity markets as two very different markets. In a doomsday scenario, we could see second Great Depression (let’s call it the Greater Depression) and the stock portion of your portfolio could lose 70% of their value while the bonds will hold their value if held to maturity (obviously depending somewhat on the rating and such things but let’s assume we are talking about high-quality and government-backed bonds). Just as it would be foolish to invest only in one sector of the stock market, do not invest only in the stock market. Invest in bonds and invest in real estate too.

Benjamin Graham says a lot about bonds and bonds vs. stocks and asset allocation in The Intelligent Investor. His conclusion at the end of chapter 2 says much the same thing as above:

Naturally, we return to the policy recommended in our previous chapter. Just because of the uncertainties of the future the investor cannot afford to put all his funds into one basket–neither in the bond basket, despite the unprecedentedly high returns that bonds have recently offered; nor in the stock basket, despite the prospect of continuing inflation.

In case you are confused, before this Graham talked a lot about the inherent risk and uncertainty in the stock market (meaning that some bonds are necessary for safety) and persistent inflation risk (meaning that some stocks are necessary as a hedge against inflation, which be be disastrous for bonds). Chapter 2 is a great read, as is Chapter 4, which talks about bond-stock allocation:

We have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks, with a consequent inverse range of between 75% and 25% in bonds.

He actually favours a 50-50 split for the “defensive investor”, shifting the balance when stocks are at “bargain levels” or when the market level has “become dangerously high.” I would warn against such market timing and stick to one allocation and re-balance when necessary. That allocation should be set to whatever is comfortable for the investor, as he says long-windedly in Chapter 2, “the more the investor depends on his portfolio and the income therefrom, the more necessary it is for him to guard against the unexpected and the disconcerting part of his life. It is axiomatic that the conservative investor should seek to minimize his risks.”

I don’t know where you get your expected returns for bonds from, but the 10 year performance of the TD Canadian Bond Fund is 5.8% and the return of XSB since inception (7 years ago) is 5.71%. I remember it being better before, so I guess recent poor performance has dragged them down a bit. For the amount of risk involved, that’s not a bad investment. There are equity markets that have performed worse over the same period according to TD’s mutual fund performance chart (Note TD International Equity at 1.4% over the past 10 years).

Of course the other advantage of having bonds in a portfolio has to do with diversification which can lead to less volatility in your portfolio. Chapter 8 of A Random Walk Down Wall Street explains this very well (to see the section I’m talking about, go Search Inside the book on Amazon and search for “the benefits of international diversification have been well documented” and you’ll get to page 192, then read on).

Personally I think bonds will beat any high interest savings account in general. And in my opinion you shouldn’t worry too much about E*Trade going bankrupt unless you have over $1 million with them. I’m not convinced that the Cash Optimizer wouldn’t be covered by the CDIC but I haven’t really looked into it so I’m not sure. Maybe another rule of thumb should be to not have all your assets at one brokerage?

As for XSB vs. XBB, Martin Gale of efficientmarket.ca complains that “the duration on these funds [XBB] was too high” making the risk-adjusted return too low compared to stocks:

Note the principle here: If you want to earn a higher return, you have to take a higher risk. Some investors try and earn the higher return by buying longer duration bonds, and taking on a higher interest rate risk. I think this is a bad idea: If you want to take on a higher risk, instead buy more equities and take on more market risk. Whatever risk/return ratio you achieved by buying longer duration bonds, you could achieve by holding fewer bonds and more equities. In general I think the equities have the better risk/return ratio. That could always change–but at least historically, it’s been the case that equities have been a better investment than long-term bonds.

You can read the full article here: “Changes To Barclays iShares: XSB and XRB” article. He was so strongly in favour of XSB and against the longer duration XBB that I went with XSB instead, along with some XRB (real-return bond index) as well (there’s also a mention of XRB in the Martin Gale article).

I hope that helps!