Reasons For Owning High-Quality Bonds

pie_flat_blank_200Here are some helpful resources on owning only bonds of the highest credit quality as part of your portfolio asset allocation.

  • David Swensen in his book Unconventional Success argued that alignment of interests is important. With stocks, the exectives want to make profits, and you want them to make profits. With stocks, your interests are aligned. In contrast, the job of bond issuers is to look as creditworthy as possible, even if they are not. This keeps the interest rates they pay lower. With bonds, your interest are not aligned. The safety ratings of bonds usually only get worse – usually quickly and unexpectedly as we saw with subprime mortgages. Ratings agencies are not very good at their jobs, mostly in a reactionary role, and are often paid by the same people they rate.
  • Larry Swedroe at ETF.com:

    However, he also observes that the primary objective of investing, at least in stocks, is to make money. On the other hand, he makes an important distinction when it comes to the primary objective of investing in bonds, which is to help you stay invested in stocks when the inevitable bear markets arrive.

    And that leads to his conclusion to invest the fixed-income portion of your portfolio in only the safest bonds (such as Treasurys, FDIC-insured CDs and municipals rated AAA/AA).

    The overall idea to is own the safest thing possible when it comes to bonds.

  • Daniel Sotiroff at The PF Engineer:

    The primary reason most investors own fixed income securities (bonds) is their ability to limit declines in portfolio value during periods of poor stock performance. From this perspective there is another dimension to safety in the fixed income universe that needs to be understood.

    […] Almost all of the non-Treasury securities experienced a drawdown during 2008 which peaked around October and November. Investors holding corporate bonds, intermediate and longer term municipal issues, and inflation protected securities were no doubt disappointed that their supposedly safe assets posted losses. Corporate bonds in particular have the unfortunate stigma of behaving like stocks during crises. Adding insult to injury those disappointed investors were also faced with taking a haircut on their fixed income returns if they wanted to rebalance and purchase equities at very low prices. Thus there is more to risk than the more academic standard deviation (volatility) of returns.

    My interpretation is that he concludes that intermediate-term Treasury notes are good balance of safety and interest rate risk, while short-term Treasury bills are for those that really don’t want any interest rate risk.

  • Also see this previous post: William Bernstein on Picking The Right Bonds For Your Portfolio

Comments

  1. Your conclusion assumes that you are Bill Gross, already have $2 billion and can live on 1-1.7% return. I would say that the article is practically meaningless in a world of zero per cent interest for eight years where people are starved for yield and forced up the risk curve to serve the usual interests and where nothing is going to change anytime soon. There is almost no option to be rational, its place your best bet or be unable to meet your needs.

  2. This argument doesn’t make much sense. It hinges on the assumption that non-government bonds are always overvalued. If it were indeed true that bonds consistently under performed, people would begin to discount the the marketing information bond issuers provide. (which I think most people do already)

    Even if you believe them, “the job of bond issuers is to look as creditworthy as possible, even if they are not.”–means that the bond issuers/the company itself will be trying to look even more creditworthy when you are trying to sell too, so its just as likely to benefit you as hurt.

  3. It’s interesting, but I personally switched to a CD Ladder at Ally. It gets about 1.5% when I mix 1-5 year CDs. It’s obviously not the same but I feel that a 1.5% return that doesn’t have the downside risk of bond fund ETFs and is simpler than buying individual bonds seems like a decent replacement?

    • Thanks Exactly what I did few years back. Whats wrongs with this. Need some monitoring and moving back into bonds when appropriate . Other than that I don’t see a need to hold bond in this market. I am not convinced. Whats wrong with this.

    • Thats Exactly what I did few years back. Whats wrongs with this. Need some monitoring and moving back into bonds when appropriate . Other than that I don’t see a need to hold bond in this market. I am not convinced. Whats wrong with this.

  4. Hermann has the right idea. High quality corporate bonds are selling way above par and bonds funds are too volatile for the 1.5% interest rate (in my opinion). I’ve owned VFSTX (Vanguard Intermediate bonds) for a while and they are still down 1% even after dividend reinvestment. The “fixed” side of my portfolio is mostly in cash or treasuries and its only job is to be available in an emergency (or down market)

  5. I agree with Hermann and Steve. Interest rates are too low, the risk/reward for Corporate bonds is not there. Ally money market pays 1% .Wait until the fixed income market returns to a state worth the risk.

    If you are 25 years old, all this is meaningless – invest in stocks for your future. If you are 60 and need to protect the downside of your portfolio – advice is most welcome.

    I appreciate this blog, thanks Jonathan!

    • I agree. If you are young there is no need for bonds. If you are old and retired, you have a multi-million dollar stock portfolio and you live on dividends (2% for S&P500 index fund) with no need to ever touch the principle. Again, no need for bonds.

  6. Borrowing a chapter from Jonathan’s playbook….if you look at Vanguard funds like BLV and VCLT, where you have an expert team doing the due diligence, their performance has continued to surprise me to the upside with +4.25% yields and continued growth even in face of what was an unlikely but still possible Fed rate increase. Though its not the perfect solution of pushing duration risk off on some one else’s shoulders at least in terms of my risk/reward calculations its preferable to 1.5% at Ally.

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