How an asset class such as bonds can play different roles in your portfolio depending on your investment philosophy.
In this episode you’ll learn:
- What are bonds and how can they be used in investment portfolios.
- What is interest rate anticipation.
- Why individuals have an advantage over institutions because they don’t have to worry about outperforming a benchmark when it comes to bonds.
- Why U.S. interest rates could rise and fall from current levels.
- Why China is unlikely to sell all of its U.S. Treasury bonds.
- Examples of higher yielding strategies other than bonds that can benefit from falling interest rates.
Show Notes
Balanced Asset Allocation: How to Profit in Any Economic Climate by Alex Shahidi
Investing At Level 3 by James B Cloonan
Episode Sponsors
Episode Summary
Why own bonds as part of our portfolios? In this episode, David explains the two driving philosophies for owning bonds and how your philosophy will influence the way you invest in them. Some use bonds as a means to generate income, while others use bonds to generate returns. The role of bonds is also influenced by whether or not you are an individual investor or an investment manager or firm. Generating a high return will more likely be important to a manager or firm that is competing with others to generate the highest possible return for a client—while an individual investor may profit more from a bond investment focused on generating long-term income.
Generating a high return on bonds is not an assured outcome
David explains that while generating a high return on your bond investments might seem like the best-desired outcome—it isn’t guaranteed, which is why diversifying your portfolio with assets that perform best in different economic scenarios helps ensure that you are seeing profit despite the sole performance of your bonds. David shares that his personal investments in bonds this year underperformed. While he would have been upset if he was still in money management, he was able to relax as an individual investor because the role he has assigned his bonds is generating long-term income. The idea is to fill your portfolio with volatile assets so that your risk is managed for various economic situations.
The necessity of speculation when investing in bonds as an individual investor
David reminds listeners to ask the question, “Is it investing, speculating, or gambling?” when considering whether to invest in a specific asset. When looking at the history of bonds, we see a strong 6.6% dividend yield on bonds back in the 1950s. Bond yields fall as interest rates rise and rise as interest rates fall. To garner a 6% dividend yield on bonds today, there would have to be at least a 60% decrease in current interest rates. Bonds are volatile. Investing in them requires speculation. Ultra short-term bonds have no interest rate risk and garner about 2.5% yield. The overall yield for the bond market is between 2.6% and 2.7%. Long-term bonds will only prove to be a profitable source of income if interest rates fall over the life of the bond. In the end, the individual investor—depending on the philosophy of investing that they are applying to their bonds—is speculating on whether or not interest rates will rise or fall. While the income return will be there no matter what—albeit it could prove to be small—the yield on short-term bonds is grounded in speculation regarding the behavior of future interest rates. Falling interest rates aren’t a guarantee.
Why own bonds when such heavy speculation is required
David explains that owning bonds as an individual investor actually gives you a leg up from investing in them as a firm or money manager because you aren’t having to compare your yield to a benchmark goal. Heavy speculation is required, yes, but you won’t be fired or lose control of the bond if it doesn’t provide a specific yield. You can use bonds as a means of diversifying and strengthening your portfolio—despite the behavior of interest rates.
David gives reasons for whether interest rates may go up or go down—showing that while speculation is a necessity of investing in bonds—it doesn’t have to rule your own use of bonds. Longer-term rates are affected by the behavior of the Federal Reserve, which has put rates on hold for now. The market is planning for cuts in interest rates in the near future, which could cause bond-yield to rise. Interest rates in the global economy are also lower than the U.S., which could prove to be good speculation that owning long-term bonds will be profitable.
On the flip side, there is no term premium priced into government bonds—the security measure used to compensate for rises in interest rates. To make up for this, interest rates could be raised to make up for there being no term premiums. Another reason interest rates could be raised higher is if investors become spooked by the high number of bonds that the government is issuing. Because bonds are debt-bearing instruments, as the U.S. debt deficit increases, interest rates could go up. The behavior of China’s treasury bonds could also affect how our own bonds behave. If China sold its Treasury holdings and converted the yield into yuan, then that puts pressure on exchange rates and creates a need for the U.S. to raise interest rates. It’s hard to say what will happen.
Again, it is all speculation. Be sure to listen to the entire episode for greater details on why interest rates may fall or rise—and why relying on speculation to determine how to invest in bonds can prove to be risky.
Deciding where to focus your bonds will help you know how to diversify your portfolio
Your bond strategy will help you determine how to best diversify the rest of your portfolio. There are other ways to invest in dividend-yielding assets, such as preferred stocks and equity real estate investment trusts. Real estate can also become a bond substitute. David explains that while there is no one right answer to how to diversify, you can make goals for your portfolio and make adjustments to your asset allocation as you compare your results with what you want accomplished through your investments. The goal should be to have assets that will return yield when interest rates go up because your bonds will inevitably go down at some point.
All assets have different roles within your portfolio. The key is to understand what philosophy—what role you want to subject your assets to, so that you can strategize most effectively. What role will bonds play in your portfolio, and are you investing in them in such a way that they fulfill that role?
Episode Chronology
- [0:20] Generating a return on bonds.
- [2:22] David explains why his own portfolio has not seen huge success in bonds.
- [3:56] What is the role of bonds in your portfolio?
- [6:41] A historical analysis of bonds.
- [9:55] The advantage of being an individual investor.
- [10:59] Speculating whether or not interest rates will go up or down.
- [14:50] The effects of the global economy on US bond behavior.
- [17:12] Strategies for diversifying your portfolio.
- [20:49] What to focus on as an individual investor in bonds.
- [22:19] Comparing the story of the carpenter and the tree to the life of a bond.
- [24:23] Deciding which path to choose for the use of your bonds.
Transcript
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