Recently a friend asked, “Pat, I see that several prominent Canadian investor advisors recently wrote articles that said it’s a bad time to buy bonds right now. Do you agree?”
He was surprised when I told him I haven’t bought any bonds for myself since the 1990s. I haven’t bought any for clients in the last couple of decades, except on client request.
In the 1990s, I used to buy “strip bonds” for myself and my clients, as RRSP and RRIF investments. This was the Golden Age of bond investing. Back then, high-quality bonds yielded almost as much, pre-tax, as the historical returns on stocks. In addition, they provided fixed income that simplified financial planning.
Bonds have tax disadvantages, of course. But you can neutralize those disadvantages by holding your bonds in RRSPs and other registered plans.
The big difference back then was that bond yields and interest rates were much higher than usual. That’s because we were still coming out of (or “cleaning up after,” you might say) the inflationary bulge of the 1970s and 1980s.
In the 1980s, government policies pushed up interest rates and took other measures to hobble inflation, and it worked. But interest rates stayed high for a long time after the government polices broke the back of inflation: kind of like finishing the antibiotic after the infection goes away.
High-quality stocks vastly superior to Bonds
Long-time readers know my general view on the stocks-versus-bonds dilemma. When interest rates are as low as they have been in recent decades, high-quality stocks on the whole are vastly superior to bonds. (See below for a further explanation). However, you have to understand the differences between the two. For one thing, stocks are more volatile than bonds. But volatility and safety are two different things.
Volatility refers to sharp price fluctuations, often due to short-term uncertainty and the randomness of short-term market movements. Safety refers to the risk of permanent loss.
Bonds improve portfolio stability but cut investment returns
The odds with bonds are the opposite of what you get in the stock market.
Inflation near-automatically reduces the purchasing power of bonds. Inflation can also hurt the returns you make in the stock market, of course. However, companies you invest in can take steps to cut the costs of inflation. They can pass on cost increases to their customers. They can introduce new processes and equipment to improve productivity and cut their costs.
In contrast, bonds and those who invest in them are generally at the mercy of inflation.
A stock can go down all the way to zero, of course. But that’s rare, and all but unknown among stocks you buy when you follow our Successful Investor approach to investing. Stock prices fluctuate, sometimes wildly. But most shares of high-quality companies ultimately head upward.
If you hold on to a portfolio of high-quality stocks long enough, the gains you get out of it will dwarf your original cost.
In bonds, the opposite is true. Bonds have a clearly defined return, based on their stated interest rate. The interest rate determines the maximum return. Of course, a bond can also go to zero, if only theoretically.
So, bonds and stocks can both go to zero. But bonds come with a cap on the maximum return they can give you, whereas stocks have no limit on how high they can rise nor how much they can pay you in dividends. That’s why we prefer to invest in stocks.
We built the fiduciary approach into our business model
When you operate as a fiduciary as we do, you do what’s best for the client. We designed our business model to eliminate conflicts of interest. We charge a percentage fee on the assets we manage for our clients.
Most bond selling/bond issuing businesses operate on a pay-per-transaction basis. You pay them every time you buy or sell. They may buy or sell on your behalf in the open market, or they may buy from you or sell for you out of their own holdings.
This business model introduces a conflict of interest. The more you buy and sell, the more money they make. That’s especially true when they operate as a principal, buying and selling into and out of their own holdings
Some advisors say that if you combine bonds and stocks in your portfolio, it will be less volatile than holding stocks alone. That’s true, and lower volatility has great appeal for some investors. But the combination doesn’t reduce risk nor increase investment income.
Bonds are one of a variety of ways for cutting the volatility in your investments. However, when you cut volatility, you also lower your long-term investment return. Your investment returns will be more stable but less profitable.
People in the bond business will advise you to methodically buy and sell bonds and stocks to preserve what they see as a favourable ratio between the two types of investments in your portfolio. This will lower your volatility all the more. It will hurt the gross return on your portfolio, compared to investing in stocks as we advise, over long periods. It will cut your net return even more, since buying and selling bonds costs money.
I mention this now because, in a volatile period like the one we are in today, some advisors will advise you to sell stocks and buy bonds. Others will advise you to trade bonds based on their predictions of bond market price trends. This improves the income of the advisor making the recommendation – more trading increases commission costs. In addition, transaction costs ae higher on bonds than on stocks.
Mind you, I disagree with the many investors today who think we are on the verge of a huge outburst of inflation. Due to the weaknesses of today’s monetary system, the risk of inflation is ever-present.
Nobody can predict trends in inflation or interest rates with any consistency. But many investors have done very well over long periods by applying our Successful Investor approach to their investments, or hiring us to do it for them.
Pat McKeough has been one of Canada’s most respected investment advisors for over three decades. He is the founder and senior editor of TSI Network and the founder of Successful Investor Wealth Management. He is also the author of several acclaimed investment books. This article was published in his The Inner Circle email newsletter on May 17, 2022 and is republished on the Hub with permission.