By Michael J. Wiener
Special to the Financial Independence Hub
Today’s long-term bonds pay such low interest rates that it makes no sense to own them. There is virtually no upside, and rising interest rates loom on the downside. Warren Buffett called this “return-free risk.” He was right. Here I explain the problem and address objections.
As I write this, 10-year Canadian government bonds pay 0.623% interest. If you invest $10,000, you’ll get a total of only $623 in interest over the decade, and then you’ll get your $10,000 back. This is crazy. Even if inflation stays at just 2%, you’ll lose $1237 in purchasing power.
Even worse are 30-year Canadian government bonds that pay 1.224% as I write this [late in October 2020.] Your $10,000 would get a total of $3672 in interest over 3 decades. This is a pitiful amount of interest over a full generation. At 2% inflation, you’ll lose $1738 in purchasing power. Even a portfolio that only beats inflation by 2% per year would gain $8113 in purchasing power over 30 years.
All investments have risk, but there has to be some potential upside to justify the risk. Where is the upside for long-term bonds? The only upside comes if we have sustained deflation. It’s crazy to risk so much just in case the prices of goods and services drop steadily for the next decade or three.
Some investors mistakenly think they can always sell bonds and collect accrued interest. That’s not how it works. With a 30-year bond, the government is promising to pay you the tiny interest payments and give you back your principal after 3 decades. If you want out, you have to sell your bond to someone else who will accept these terms. You don’t get accrued interest; you get whatever another investor is willing to pay. Counting on selling a bond is hoping for a greater fool to bail you out. If future investors demand higher interest rates on their bonds, your bond will sell at a significant capital loss.
If the interest rate on 30-year bonds goes up over time, that’s actually bad for current bond owners, because they have to live with their lower rate instead of receiving the new rate. If 30-year bond interest rates go up by 1%, you immediately lose 30 years of 1% interest; you can’t just sell to avoid the loss because other investors wouldn’t happily take these losses for you.
Let’s go through some objections to this argument against owning today’s long-term bonds:
1.) Stocks are risky
It’s true that stocks are risky, but I’m not suggesting that investors replace long-term bonds with stocks. Short-term bonds and high-interest saving accounts are safer alternatives. A decision to avoid long-term bonds doesn’t have to include a change in your asset allocation between stocks and bonds. For anyone willing to look beyond Canada’s big banks, it’s not hard to find high-interest savings accounts paying at least 1.5% and offering CDIC protection on deposits. If long-term bond interest rates ever return to historical norms, it’s easy to move cash from a savings account back into bonds. So, you don’t have to live with a measly 1.5% forever.
2.) Investors need to diversify
The benefit from diversifying comes from owning assets with similar expected returns that aren’t fully correlated. However, the expected returns of today’s bonds are dismal. We don’t really own bonds for diversification these days. The real reason we own bonds is to blunt the risk of stocks. It doesn’t make sense to try to reduce portfolio risk by buying risky long-term bonds. Flushing away part of your portfolio with long-term bonds isn’t a reasonable form of diversification. Short-term bonds and high-interest savings accounts do a fine job of reducing portfolio volatility without adding significant interest rate risk.
3.) Long-Term bonds have higher interest rates than short-term bonds
Historically, long-term bonds rates usually have been higher than short-term rates. Today, however, high-interest savings accounts pay more interest than long-term government bonds. But that’s not the only consideration. Interest rates will change over the next 30 years. If you own short-term bonds, your returns will change too. However, if you buy 30-year bonds, your interest rate won’t change for three decades. If interest rates rise, new short-term bond rates will be higher than your old 30-year rate.
Even if long-term bond rates rise, that won’t change your interest rate. New investors will get more interest, but your bonds will still be locked into the same low rate.
4.) All durations of bonds have done very well for almost 40 years
Interest rates peaked in 1981 and have declined steadily since then (with some bumps along the way). Investors who bought bonds that paid high interest rates have been able to sell them at a premium because their high interest payments keep looking better as interest rates on new bonds decline. Unless you believe interest rates can go negative to -10% or lower, the next 40 years can’t look the same. If interest rates ever return closer to historical norms, long-term bonds will get clobbered.
5.) My favourite ETFs contain long-term bonds
Almost all balanced funds and bond funds contain some long-term bonds. My favourite ETF company is Vanguard because of their focus on treating investors well. Vanguard Canada has a great lineup of asset allocation ETFs that allow investors to buy just one ETF for their whole portfolio. Unfortunately, these asset allocation ETFs, including the new retirement income ETF called VRIF, contain long-term bonds. I’d like these products a lot better if the only bonds they held were short term.
Throughout history, it has made a lot of sense to own a diversified set of stocks along with government bonds of various durations. Looking back in time, we recognize stocks bubbles, but I’ve never been sure I was in a stock market bubble while it was happening. So, I’ve maintained my allocation to stocks through thick and thin. But it’s not hard to see the problem with long-term bonds today. They have plenty of downside possibilities with almost no upside.
Unfortunately, almost all simple balanced investment options for Canadians include long-term bonds. The simplest reasonable investing solution I see for a do-it-yourself Canadian is to own Vanguard Canada’s VEQT for the stock allocation, and place the fixed income allocation in short-term government bonds or high-interest savings accounts (not from a big bank). For those using advisors, good luck convincing your advisor that long-term bonds aren’t worth owning.
None of this is intended as investment advice. I spend time thinking and writing about how to invest my own money. I’ve always preferred to keep my fixed income investments liquid, and I’m more certain than ever that I don’t want to own long-term bonds.
Michael J. Wiener runs the web site Michael James on Money, where he looks for the right answers to personal finance and investing questions. He’s retired from work as a “math guy in high tech” and has been running his website since 2007. He’s a former mutual fund investor, former stock picker, now index investor. This blog originally appeared on his site on Oct. 27, 2020 and is republished on the Hub with his permission.