Bonds

August 18, 2018

What are bonds?

Bonds are a form of “a loan or IOU” (Wikipedia). Typically when we buy bonds, we are loaning money out and expecting to get a return based on the likelihood of the lender, either the government or a business, repaying that loan. The return is known as the coupon which is the interest that the lender pays you for loaning them money. Less risky lenders such as the US government would pay less in interest because they would be more likely to pay back that loan. More risky bonds, the most risky of which are called “junk bonds”, must offer higher returns to justify the higher chance that the companies offering these bonds will default on their money.

John Bogle describes bonds as a commodity-like security in a highly efficient market.[1] This definition means that there are many of these individual bonds that all have similar returns. Individual stocks on the other hand are not expected to all follow the same rate of return since their prices will zig and zag in different directions.

At the end of the day since bonds are a safer asset and thus have lower expected returns, they aren’t as sexy as stocks but they do play an important role in investing so pay attention to learn about them!

Role of Bonds in Your Portfolio

Bonds are generally used to balance the downside risks of stocks in a portfolio. For example, if you are newly retired, a market crash could hurt your portfolio just as you start taking out money. In 2008, the stock market fell 57%. During the Great Depression, stocks fell 89%! The more stocks you hold, the more your portfolio will drop in these crashes. By holding bonds, you reduce that risk because bonds have a rate of return that are defined ahead of time. In addition, if a company goes bankrupt, they are required to pay off their lenders (bond owners) before they can pay a penny to the shareholders (stock owners). Although companies may default on bonds, the U.S. government has yet to default on repaying a bond.

The balancing of downside risks may be the most important aspect of bonds. It’s easy to look at charts and the percent return you would get from different asset allocations and want to choose 100% stocks because that has the highest return. However, if we hold a smaller bond to stock ratio than we can stomach, when the market crashes we may chicken out and sell. Then it may have been better if we didn’t invest in the first place since selling in a down market is the only way to lose money in a market that is always going up over the long run.

The other reason we would want the risk reduction of bonds is that we may be within 10-20 years of retirement age and although we claim that we can handle the volatility of the stock market, bonds have actually outperformed stocks in about 1 out of every 21 rolling 25-year periods from 1802 to 1999 when John Bogle wrote Common Sense on Mutual Funds (e.g. 1802-1827 and 1803-1828 would be the first two rolling 25-year periods). If we cannot or definitely do not want to work another 10 years, then we should take the lower risks and returns to protect our portfolio. After we retire, the bond portion of our portfolio allows us to rebalance and buy back into stocks during market crashes when stocks are on clearance sales.

Bonds can also be seen as a deflation hedge. Deflation is when currency is worth more so it costs less to buy goods. Since the terms of the bond are agreed on when the bonds are issued and bought, the rate of return is fixed as long as the borrower does not default on the bond. This means you know exactly how many dollars you should be getting back from each of your bonds. If the dollar were to start gaining value due to deflation, then these fixed dollar amounts would become more valuable.

Riskiness of Bonds

Although bonds are supposed to reduce the risks in our portfolio, they do carry some of their own risks.

Default Risk

The default risk is the risk that the issuer of a bond will fail to make the agreed payments. Bonds are given a rating (similar to a grade in school). Different rating companies (the big 3 are Moody’s, Fitch, and S&P) give ratings to bonds and each company has their own scale. These ratings are a measure of how likely an issuer is going to pay off a bond. When aiming for better returns than those offered by bonds with the best credit ratings like Microsoft, Johnson and Johnson, Exxon Mobil, and the US government, we usually need to buy bonds will lower quality ratings. Although this means that they are more likely to default, by buying a bond fund we can diversify the risk of a single bond defaulting by holding a wide variety of bonds from different companies.

Companies struggle and are more likely to default on bond repayments during market crises. Since these market crises are when stocks are tumbling, we want to hold higher quality bond funds so that the bond portion of our portfolio does not fall as much due to default.

Interest Rate Risk

Rising interest rates cause bonds prices to fall. When interest rates rise, the new bonds that are offered with identical terms and ratings as older bonds will have a larger interest payment. Thus, these newly issued bonds are worth more than the bonds from before which had a lower interest payment per pay period even if no interest has yet been paid for those older bonds.

For example, let’s assume we buy a government bond today for $100 which pays back $110 in 10 years. If we try to sell it today, someone would be willing to buy it for the same $100 we spent on it. If interest rates go up, tomorrow the government may offer a bond for $100 which pays back $120 in 10 years. Now if we tried to sell the original bond we bought the day before, we would not be able to sell it for $100. This is because one could pay $100 for a government bond which returned $120 instead of $110 after 10 years. Thus, if we needed to sell the bond we would have to settle for less than $100.

Inflation Risk

This is the risk that the dollar amount that each bond returns will be worth less because of inflation. Since the returns are fixed when the bonds are issued (again assuming that the issuer doesn’t default on the bond), a weaker dollar means less buying power with that same dollar amount in the future.

Again, let’s assume we buy a government bond today for $100 which pays back $110 in 10 years. Today, that $100 can buy us 20 $5 In-N-Out burgers. However, if we have inflation over the next 10 years and In-N-Out burgers are worth $55 then, we can only buy 2 In-N-Out burgers with the $110 we get from the bond in 10 years.

Bond Funds vs Individual Bonds

Why would you hold a bond fund instead of individual bonds?

Assuming they are government bonds they could be considered riskless in terms of default, the famous investor Peter Lynch doesn’t see the need for bond funds. John Bogle suggests that bond funds gives us the advantage of having a fixed maturity date (the average length of time that the bonds will generate income before they are paid off) since as bonds mature they will be replaced by newly issued bonds.

However, bond funds with high costs are robbing their investors. Lower cost bond funds, especially bond index funds, are almost guaranteed to outperform in the long run. The outperformance of low cost bond funds is even more guaranteed than for stock mutual funds because bonds have a fixed rate of return. Since there is a fixed rate of return, there are no Warren Buffett’s or Peter Lynch’s of bond investing who can outperform by selecting superior bonds.

Individual bonds also may carry additional risks such as being paid off ahead of time which means we stop getting interest(these are known as callable bonds) or the risk of not having many buyers and sellers.

Taxes

Tax Efficiency

Almost all of the return from bonds come from dividends which are taxed as ordinary income. In contrast, stocks get most of their return from price gains which since we will be buying and holding for the long term will be taxed at the long term capital tax rate. The long term capital tax rate is lower than the marginal income tax rate. Thus, bonds are generally more tax inefficient than stocks. However they are usually still more efficient than actively managed stock funds which generate more stock turnover and thus more taxable events.[2] These active funds generally trigger short term capital tax gains as well when stocks are not held for at least a year.

Because of this relative tax inefficiency, I would try to put my total bond market funds into a traditional 401k or IRA to take advantage of not having to pay taxes on the dividends until the money is withdrawn. However, since bonds have a lower expected return than stocks I would not put them into a Roth 401k or Roth IRA since those accounts have already been taxed and in the long term we would rather withdraw more money from those accounts since all that money can be withdrawn tax free.

Treasury Bonds

Treasury bonds are bonds issued by the United States government. As such, they are exempt from state taxes.

Municipal Bonds

Municipal bonds are just a fancy name for bonds that are exempt from federal income tax and usually state income tax as well. However their gross returns are usually lower to offset this advantage. They could make sense for people in high income tax brackets holding these bonds in taxable accounts. Vanguard has funds for municipal bonds too.

How much to hold?

Determining what percentage of your portfolio to hold in bonds is largely a matter of personal risk tolerance based on your situation. There are common recommended rules of thumbs such as holding your age in bonds. There are simple 3-fund portfolios such as that recommended by William Bernstein that just recommend holding 1/3rd of your portfolio in bonds for your whole life.[3]

Early Retirees

Early retirees should not hold more than 50% of their portfolio in bonds if they are withdrawing 4% of their portfolio a year. The 4% safe withdrawal rate is from the Trinity study which researched the chances of a portfolio surviving historical 30 year periods at different withdrawal rates. Jim Collins, the author of the Stock Series, holds 25% of his portfolio in Vanguard’s Total Bond Market Fund (VBTLX).[4] Some, such as Jeremy and Winnie from Go Curry Cracker, opt to hold no bonds because their portfolios are large enough to weather downturns and still support them so they would rather optimize for the potential growth of their portfolio for their heirs.[5]

Pitfalls

The danger of overallocating in stocks and underallocating in bonds is that in the next great market crash, we either chicken out or we are forced to take money out to support our standard of living. Also in good years, our stock allocation might grow too large and we will need to rebalance to get back to our target allocation. Rebalancing is really important because your portfolio allocations will change and no longer accurately reflect your ability to take risk. For example, a 50/50 stock bond portfolio could become a 75/25 stock bond portfolio over a time period where stocks outperform bonds. Suddenly we have the risk of 75% stocks even though we can only handle the risk of 50% stocks.

Rebalancing also encourages buying the asset that is on sale relative to the asset that has performed better which may improve your performance over time. If you can’t be bothered to rebalance once a year, a Target Date Retirement Fund or LifeStrategy Fund may fit your needs better since they will rebalance automatically. I recommend Vanguard’s for their low fees and unique management structure.

On the other hand if you are terrified of stocks and hold too much of your portfolio in bonds, you could be hurting your long term performance especially if you are a young investor. Not holding enough stocks are just as risky since your buying power may be ravaged over time by inflation and you will need to save much more to sustain the same standard of living in retirement.

Finally, our discussion of the risks associated with stocks and balancing that by holding bonds only holds true with low cost index funds. Once you venture into individual stock picking, downside risks can be quickly amplified since individual companies will go bankrupt. In addition, the higher expenses associated with buying and selling individual stocks will ravage your portfolio for no additional reduction of risk or increase of return.

What I hold

I currently have about 2% of my portfolio in Vanguard’s Total Bond Market (VBTLX) and Total International Bond Market Funds (VTABX). This is not by design since my target allocation is 0% but I hold the Vanguard Target Date 2060 Retirement Fund in my 401k which has around 10% bonds. If I live to my expected life expectancy, I will have many years for my accounts to grow. Since I am young, hold an emergency fund, have very low expenses, and definitely would not sell stocks when they go on their 50% off sales, I am comfortable with the volatility and risk.

Some studies suggest that 90% equities actually outperform 100% equities due to having the money in bonds to sell and buy more stocks when the market is down and buying more of whichever asset has underperformed when regularly contributing.[7] Since I am currently earning income, I see my income as my fixed income stream and I own international stocks which allow me to buy more of the asset that has underperformed each paycheck cycle. Since international stocks have a higher expected rate of return than bonds, this should increase my expected returns over a 90/10 stock-bond split. However, the downside of my approach is that international stocks are more correlated to domestic stocks than bonds with the increasing globalization of companies. This means that in a market downturn, there will be less risk reduction and the correlation will limit my ability to buy the relatively cheaper asset. Vanguard usually holds both international stocks and domestic and international bonds in their Target Date Retirement Funds and LifeStrategy Funds. For simplicity sake, and the current lack of a low cost bond market fund in my 401k, I will not include bonds in my target allocation at this stage.

Right before I retire or reach financial independence, I plan to invest in the Vanguard total bond market funds in my 401k until they make up 25% of my portfolio. If I retire before I reached 25%, I would just sell my total US stock market (VTSAX) holdings in my 401k to buy more bonds. Since these transactions would happen in a tax advantaged account, I wouldn’t need to worry about being taxed on the capital gains.

What I recommended for Mom

My mom is close to the perfect investor because she doesn’t pay attention to her investments especially during market downturns. In fact, if her portfolio fell she would just give thanks to God that she had that much to lose. She has never sold in panic. She plans to work for approximately 10 more years and has enough to sustain her standard of living. When I showed her Vanguard’s comparison of returns and downside risk for various investments she wanted to go for the highest return. Since she weathered the bear market of 2008 without so much as looking at her 401k, I had reason to believe that she would be able to weather the storms. However with only 10 years of her working career left and enough to sustain her current modest standard of living, it didn’t make sense to take on unnecessary risk. I would recommend Vanguard’s LifeStrategy Fund with a 60-40 stock bond split if she were retired. But since she had approximately a decade left we ended up choosing a Vanguard Target Date Retirement Fund that was around 70-30 stocks to bonds and would slowly transition to have more bonds. By the time it reaches 60-40, we will transfer it to the 60-40 Vanguard’s LifeStrategy Fund since we don’t see a need to go more conservative than that.

My mom’s strategy is slightly less tax optimized since we don’t split up stocks and bonds and the expense ratios are slightly higher than holding the individual funds that make up the Target Date Retirement Fund. However, since she has no interest in managing her investments, this gives her more time to do other things that are more important to her.

Final Thoughts

Bonds are an important part of a portfolio suited to meet your risk tolerance. Too much bonds and your portfolio will not grow to its potential over several decades. Too few bonds and you may not have the money you need when you need it. Once you have an allocation set, stick to it and rebalance yearly. The path is simple but fraught with danger if you don’t stick to your plan.

Actionable Items

Consider your stage of life and the factors that affect your risk tolerance. Try to come up with a target stock-bond allocation and email it to yourself so you can look back on it in the future. Remember that perfect is the enemy of good and that you may refine your target allocation in the future as long as it is not in response to short term market highs or lows.