Confessions of a Bond Investor
5 minute read time
I admit it. I own bonds.
The S&P 500 Index is up about 20% this year. Stodgy bank and oil stocks, which were last year’s laggards, are up around 30%. Elon Musk’s Tesla, the maker of sleek electric vehicles with self-driving technology, trades at close to $750/share, up seven-fold from its pandemic low in March of 2020. Over the same period, my bonds have earned bupkis.
I am 43 years old. With any luck, my investment horizon is decades, not years. Based on both stock market history and our best estimates about the future, to maximize the growth of my investment portfolio I should own stocks. Without them, my ability to keep up with inflation, let alone outpace it, is doomed. And yet, I own bonds.
What is wrong with me? In a word: experience.
Risk Tolerance Is Real
Before we invest a dollar on behalf of our clients, we ask each one of them to answer a series of questions. What is your income? How much do you spend? When do you hope to retire? What is your risk tolerance?
I have always thought that the last of these is the most difficult to answer, primarily because it is hard to imagine, in the abstract, the fear that short-term losses in our portfolio can induce. We like to imagine ourselves buying low and selling high, but research tells us that most of us do just the opposite. Our emotions take over at just the wrong time.
I learned a hard lesson in risk tolerance as a young man. The first time I had any money to invest on my own was in the late 90’s. The dot.com craze was in full swing and my stockbroker invested my portfolio in the ETF that tracked the Nasdaq 100, the tech-heavy index that marketed itself as “the stock market for the next hundred years.” The total return for the Nasdaq 100 from 2000-2009 was -50%. I sold my position when I could no longer bear to look at my statements.
Experience has taught me that I cannot tolerate a 50% drawdown in my investment portfolio without making emotional decisions. It was a costly and painful lesson, but one that served me well during the Great Financial Crisis and again during the pandemic. In both cases, bonds offered safety and stability. They helped me sleep at night, and they gave me the courage to rebalance my portfolio when I least wanted to.
Cash is Trash But Bonds Aren’t Bad
Cash makes a tremendous amount of sense in the context of an emergency fund, but today perhaps a little less sense in an investment portfolio. At JFG, we have been keeping cash at a minimum because it yields nothing, thus locking in a negative “real,” or inflation-adjusted, return.
Under normal circumstances I would argue that there are three reasons to own bonds: safety, liquidity, and income. In today’s low interest-rate environment, those three reasons are safety, liquidity, and the ability to outperform cash. That is the second major reason why I own bonds in my portfolio. I refuse to accept zero return.
As a member of the Fixed Income Group at JFG, it frustrates me when I hear people say that “bonds are bad” because interest rates are low. While it is indisputable that bond yields are low by historical measures, the opportunity set within fixed income is so large and diverse that such blanket statements have no meaning.
The “quilt” below illustrates the broad range of returns among different bond market sectors since 2008. Just this year, there is a difference of over 8 percentage points between high-yield bonds’ 4.5% gain and local currency emerging market bonds’ -3.6% decline. In 2009, there was a 61.8% spread between the returns on high yield bonds and U.S. Treasuries.
Source: JP Morgan Guide to The Markets
Our task as advisors is to find the best relative value among this varied universe for our clients each day. To be sure, the low-rate world we live in is one where our focus is on hitting singles through security selection and sector rotation. Home runs are for a different day, but I am confident that we can outperform cash over a one-to-two-year time horizon, while benefitting from bonds’ traditional role of diversification.
Look Elsewhere For Income
You may have noticed that I removed “income” from my reasons for owning bonds. While it is not impossible to find yields of 3% to 4% in the world of fixed income today, the reality is that only the riskiest sectors of the market offer that level of income, and investors who chase yield risk eroding the diversification benefits that high quality bonds provide.
In my own portfolio, I am looking elsewhere for income. Alternatives, or complements, including real estate, direct lending strategies, and real assets (such as farmland and timberland), offer compelling income potential and less sensitivity to interest rates than traditional bonds. These strategies may also prove valuable if today’s heady inflation prints prove to be more than transitory. Landlords can raise rents as the cost of living increases, and floating-rate loan coupons rise with interest rates, while traditional bonds’ coupons remain fixed until maturity.
Own Bonds, But Don’t Own All Bonds
So, yes, I admit it. I own bonds. But I also own stocks, and complements, and I keep enough cash in reserve to help me sleep at night. Most importantly, twenty-plus years of investing through various market cycles has taught me what my risk tolerance is. If you aren’t sure what yours is, or if you think it has changed since you answered those questions a few months or years ago, give us a call. We’d love to hear from you.
This information is for educational and illustrative purposes only and should not be used or construed as financial advice, an offer to sell, a solicitation, an offer to buy or a recommendation for any security or investment. All information presented is considered accurate at the time of publication but no warranty of accuracy is given and no liability with respect to any error or omission is accepted. Charts and graphs, in and of themselves, should not be used as a basis for investment decisions. Past performance is not a guarantee of future results.
Complementary investments introduce risks that are different from more traditional investments and may require certain investor qualifications. These risks include more speculative strategies that may increase volatility and the risk of investment loss, illiquidity, lack of pricing or valuation information, complex tax structures and delays in distributing important tax information. Additionally, complementary investments often have more complex and higher fee structures than traditional investments. Higher fees reduce investor returns.
Johnson Financial Group is the parent company and brand name for its subsidiaries, Johnson Bank, Johnson Wealth Inc., and Johnson Insurance Services, LLC. Additional information about Johnson Wealth Inc., a registered investment adviser, and its investment adviser representatives is available at https://www.adviserinfo.sec.gov/. Johnson Financial Group and its subsidiaries do not provide legal or tax advice.