With interest rates rising does it still make sense to own bonds?
This episode explores the role of bonds including why they are more effective at hedging stock losses than protective put options.
Topics covered include:
- David’s business and investment philosophy
- How bond funds have performed in 2021
- Three disparate views on the direction of interest rates from Capital Economics, Ray Dalio, and Hoisington Investment Management Company
- How to invest in China bonds
- Why owning bonds is cheaper and more effective at hedging stock market losses than put options
- How covered call strategies work
- How to decide on your allocation to bonds versus stocks
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 it. I’m your host, David Stein. Today’s episode, 337. It’s titled, “Why in the world do we own bonds?”
Six Week Increments
I’ve been a long-time client of Basecamp, the web application company co-founded by Jason Fried and David Heinemeier Hansson. I have used their simple note-taking platform Backpack since 2005. We use their project management platform Basecamp. I recently switched my personal email to their premium email service Hey. Not only do I admire and use Basecamp’s products, but their corporate ethos has inspired me for years, and has influenced how I run Money For the Rest of Us. Fried and Hansson shared much of their philosophy of work and business in their books Rework and It Doesn’t Have to Be Crazy at Work.
In a recent blog post, Jason Fried discussed one of the core tenants of Basecamp. They work in six-week increments. They don’t have any big plans beyond that. That’s their project timeline. He writes “We have some big-picture directional ideas of where we may be headed, like a sailor on an exploratory expedition, aiming for a distant shore, but we’re tacking with the prevailing winds, and our whims until we eventually get somewhere good.”
He points out that the big advantage of figuring out as they go is they can adjust, they can adapt. They can make adjustments daily, and it helps them avoid big mistakes. And they’re not majorly entrenched in one idea. The time window is only six weeks.
I have a similar approach in terms of how I run Money For the Rest of Us. I don’t have any revenue goals, no profit goals. My emphasis is, simply: consistently create value-added content on money, investing and the economy, content that helps individuals feel more confident about their investing, without needing to be an expert.
Investing is the same way—we can adjust as we go along, and not become majorly entrenched in one view of the world. My investment process is to understand what current conditions are. What are economic trends, valuations, market internals—such as the level of fear and greed. I want to understand what the drivers of the returns are. What’s the current yield, what’s a reasonable assumption for income growth, and what are investors paying for that income stream.
I don’t know where markets are going to go this year. I’m just willing to adapt as conditions change and opportunities arise. It’s an asset garden approach. Many different types of assets. Fried points out that if something goes wrong because their time horizon is only six weeks, they have limited downside on any one project. By holding a diversified mix of assets and not overly-weighting any particular area, we can also protect and limit our downside.
Last July in an episode on “Investing is not knowing” I quoted the ancient Chinese philosopher Zhuangzi, who wrote, “Not knowing is knowing, and knowing is not knowing.” There is a lot we do not know about what’s going on in the investment markets, and we can be comfortable with that and invest accordingly. This year there has been a lot of hoopla that interest rates have risen, and bond funds have fallen. If we look at the return of the Vanguard Total Bond Market Index, it has lost 3.7% year-to-date. It’s not a particularly compelling fund, in my opinion, because its yield is only 1.4%, yet its duration, its interest rate sensitivity is 6.6 years.
I have about 10% of my net worth in bonds, in five different bond funds. The worst-performing one, the Dodge & Cox Income Fund is down 2.6%. I have another actively-managed bond fund that’s down 1.4%. I have a closed-end bond fund that’s up 6.7%. Another closed-end fund that’s up 0.4%, and an interest rate hedged ETF that’s up 0.4%. The increase in interest rates hasn’t really impacted me that much. Different funds have performed differently in that environment. That’s what diversification is.
I have assets that have done very poorly this year. Gold is down 10%. And others that have done extremely well. Small-cap value stocks—up 15% or more. This has been my approach to investing for decades—to understand what is going on, make adjustments as opportunities and risks arise, and not go all-in with one particular idea.
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