255: With Interest Rates Falling, Why Do You Own Bonds?

Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about. I’m your host David Stein, today’s episode 255, it’s titled “With Interest Rates Falling, Why Do You Own Bonds?”

Last week we reviewed the case for investing all of your assets in stocks. We recognize, if you do, you have to be willing to lose 60% or more of your investment portfolio when stocks plummet, because stocks do. And you have to have the fortitude to ride it out. Many of us, including me, we don’t have that. We don’t have the ability to ride the stock market up and down like a roller coaster. So we diversify and own other asset types. One of those asset categories that we own is bonds.

What are Bonds?

Bonds, also known as fixed-income, are debt instruments. They’re issued by governments and corporations. Those entities borrow money and then they pay interest on that debt and when the bond matures they return the principle.

The value of bonds varies as interest rates change. As interest rates go up, the value of bonds fall. And as interest rates fall, as they have done this year, then the value of bonds goes up. The broad U.S. bond market, the Bloomberg Barclay U.S. Aggregate Bond Index has returned 5% this year. Long-term U.S. Treasuries have returned over 10%.

But not in my portfolio. My largest bond fund has only returned 2.8%, year-to-date. I have a bank loan fund, to the floating rate fund that’s returned 4.6%. But I also have ultra short-term bond funds that returned 1.6%-2%. The competitive side of me, the one that used to be an investment manager and working to outperform a benchmark for my clients, it feels bad when the bond market is up 5%, and yet my bond portfolio is not. It’s lagging, it’s underperforming. And we know why it’s doing it.

I was reminded of that this past weekend. LaPriel and I were in Missoula for a wedding reception. And we decided to take the long way home, this past Sunday. So we headed south, along U.S. 93, just north of Salmon, Idaho where the U.S. 93 follows the Salmon River there was a house. And outside the house, there was a hand-painted sign that said in bold letters, “Not my cows.”

What in the world did that sign mean? Well, I knew as soon as I saw what it meant. When we had a farm in Teton Valley, we allowed a friend, a farmer, to pasture some cows for the summer. I looked out the window one day and I saw one of the cows was in the middle of the barley field, no longer fenced in the pasture. I went outside, and LaPriel and I tried to get the cow back in the pasture. There were actually two or three that had escaped.

Cows are not smart. One ran straight through the fence to get back in. The others wouldn’t go through the gate. It’s kinda a pain. And when you live near a pasture, maybe this person is renting a house, cows get loose. And they were tired of having someone knock on the door and tell them, “Your cows are loose.” “They’re not my cows.” said the sign. It gets down to the role of that person; that person’s role was not to take care of cows. We have to do the same in our portfolios. What is the role of bonds in your portfolio? Is it to generate returns, like we’re seeing today, when interest rates fall? Or are they primarily there for income?

What are the roles of bonds?

The role of bonds in your portfolio depends on your investment philosophy. For example, a little over a year ago in episode 201 of the show, it was titled “Is Your Portfolio Balanced?,” we discussed a book by Alex Shahidi called Balanced Asset Allocation. His view is you don’t want to rely on a single asset category, such as stock, to provide financial returns. He said, “We should own asset classes that are as volatile as stocks, but that perform better in different economic regimes.”

So his recommended portfolio included 30% in long-term Treasury Inflation-Protected Securities, or TIPS, 30% in long-term bonds, 20% in stocks, and 20% in commodities. This is somewhat similar to Ray Dalio’s Bridgewater Associates All Weather Portfolio. So you have volatility in all aspects of your portfolio.

Bridgewater does something called risk parity. They use leverage so that the volatility of bonds is equal to stocks. And so they want to keep every asset type with similar volatility, in terms of how high are the highs, how are low are the lows, in terms of the range of returns. Now that’s a specific investment philosophy. And in this environment, with rates falling, that has led to the appreciation of those bonds. This idea of leveraging out bonds, or owning very, very long-term bonds who have similar volatility with stocks and, potentially in some environments, better returns than stocks, is different than how I approach bonds.

My primary reason for holding bonds is to generate income and protect against capital losses, so that I have money, capital, to deploy when there is a more compelling opportunity. Bonds, for me, is just a safe place, a place to store money to pick up some yield. So when I invest in bonds, instead of stocks, that’s what I’m doing.

Now James B. Cloonan, mentioned his book last week, Investing At Level 3, would say moving money and holding it in ultra short-term bonds, for example, that the cost is too high. You should be all in equity. But that’s a price I’m willing to pay for the optionality to deploy those investments in an environment when there’s a regime change when stocks are attractively priced. It would be really wonderful if it ever got that point again.

I did a backtest on Money for the Rest of Us Plus last week, and I was looking at the returns for stocks for the decade of the 1950s. And the starting dividend yield for stocks January 1st, 1950 was 6.6%, and the price-to-earnings ratio was 7. Stocks in the 1950s returned 19%, annualized. That combination of very high dividend yield, which by the end of the decade was over 3%, but not 6, price-to-earnings ratio had increased to around 16, and then with the earnings growth, you had a 19% return.

Now to get to a 6.6% dividend yield, we’d have to have a huge decline in the stock market, 60% or more type of decline. But if we do, I have money in bonds that wouldn’t have lost that and then I can deploy that. That’s a different philosophy of investing in bonds.

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