By Mark Seed, myownadvisor
Special to Financial Independence Hub
“Many investors have been saying for years that rates can only go up from here, rates can only go one direction, rates will eventually go up. Will they?” – My Own Advisor, September 2021.
My, how things can and do change.
In today’s post, I look back at what I wrote in September 2021 to determine if I still feel that way for our portfolio.
Why would anyone own bonds now?
Why own bonds?
For years, decades, generations in fact, bonds have made sense for a diversified, balanced portfolio.
The main reason is this: bonds can reduce volatility due to their low or negative correlation with stocks. The more that investors learn about diversification, the more likely they are to add bonds to their portfolios.
That said, they don’t always make sense for everyone, all the time, always.
I’ll take a page from someone who was much smarter than I am on this subject:
Ben Graham, on stocks, bonds and cash. Source: The Intelligent Investor.
Another key takeaway from this specific chapter of The Intelligent Investor is the 75/25 rule. This implies more conservative investors that don’t meet Ben Graham’s criteria above could consider splitting your portfolio between 75% stocks and 25% bonds. This specific split allows an investor to capture some upside by investing in mostly stocks while also protecting your investments with bonds.
Because stocks offer more potential upside, there is higher risk. Bonds offer more stability, so they come with lower returns than stocks in the long run.
As a DIY investor, this just makes so much sense since I’ve seen this playout in my/our own portfolio when it comes to our 15+ years of DIY investment returns. Our long-term returns exceed the returns I would have had with any balanced 60/40 stock/bond portfolio over the same period.
There is absolutely nothing wrong with a 60/40 balanced portfolio held over decades, of course.
From Russell Investments earlier this year:
“Fixed income has historically been considered the ballast in a portfolio, offering stability and diversification against equity market fluctuations. Over the last 40 years, a balanced portfolio of 60% Canadian equities and 40% Canadian bonds would have returned 8.5% annualized with standard deviation of 9.3%. While a portfolio consisting solely of fixed income would have had lower return with lower risk, a portfolio consisting solely of equities would have had only slightly higher return but substantially higher risk.”
|1/1983 – 12/2022||Canada Equities||Canada Bonds||Balanced Portfolio|
Pretty darn good from 60/40.
So, while I continue to believe the main role of bonds in your portfolio is essentially safety – not investment returns – we can see above that bonds when mixed with stocks can be enablers/stabilizers and deliver meaningful returns over long investment periods as well.
As Andrew Hallam, a Millionaire Teacher has so kindly put it over the years, including some moments on this site to me:
… when stocks fall hard, bonds act like parachutes for your portfolio. Bonds might not always rise when the equity markets drop. But broad bond market indexes don’t crash like stocks do …
Is that enough to own bonds in your portfolio?
Here are a few reasons to own bonds, in no particular order:
1. Bonds can be used to counter stock market volatility.
Call them parachutes or anchors or use any other metaphor you wish but bonds tend to do their jobs when stock markets tank. 2022 was an exception. 60/40 balanced portfolios are not dead but they did take a beating in 2022.
Many investors, dare I say most investors (?), have a hard time with market volatility. I’m certainly not immune to it. The ups and downs, especially the big market downs, can be gut-wrenching to live through. Owning bonds in your portfolio can help bring the overall portfolio volatility down a few notches through prudent asset allocation.
Personally, I’ve tried to learn to live with stocks as much as possible for as long as possible.
Depending on your goals, taking into account long-term potential reward against short-term price fluctuations, some investors may not be comfortable with a 100% equity or near-equity portfolio.
2. Bonds can be used to rebalance your portfolio.
Even though I’m not a huge fan of bonds myself, this might be one of the most compelling reasons to own bonds at any age.
When the stock market sells off, that’s ideally the time you want to dive in and buy your stocks on sale.
However, unless you are very comfortable with leveraged investing – you need money to buy such stocks on sale. That can come from cash savings for sure but for many investors, that can also come from bonds within your portfolio.
In our portfolio, because we’ve largely learned to live with stocks, we tend to buy more stocks when they come on sale and/or we buy stocks periodically during the year to increase our equity holdings from any cash balance built up over the year.
Using the cash, in recent years, I’ve been moving away from just a concentrated basket of Canadian dividend-paying stocks for income and owning more low-cost ETFs instead for extra diversification.
Instead of selling bonds to buy our stocks, I therefore use cash savings.
I will continue to use cash savings to make more equity purchases as I enter semi-retirement.
Consider keeping this much cash on hand yourself – in your asset accumulation years or retirement years.
3. Bonds can be used to spend cash when essential.
Can you have too much money saved up for retirement?
Can you have too much money in your RRSP?
For 99% of Canadians, I doubt it. 🙂
At the end of the day, having a nest egg in your 50s and 60s that forces you to navigate the tax implications of your RRSP decisions is a great problem to have. I hope to be “that guy.”
However, if you needed to tap your RRSP or any part of your portfolio in an emergency, for a big expense, then selling off fixed-income assets can be the best decision you can make.
Big picture, we already know that stocks tend go up more than they go down. The problem is, we simply don’t know when nor by how much.
Yet thanks to the power of long-term human productivity and innovation over time, unless something changes, stocks should continue to rise more over time and deliver returns to investors who ride equity markets accordingly over bonds. The risk premium is there for stocks over bonds. Your potential return compensates investors for taking on the higher risk of equity investing.
Should you need to access your portfolio for any financial lifeline, then consider selling some bonds for cash. At least that’s my thinking.
Why would anyone own bonds now summary
No doubt the list goes on …
Generally, investors who plan on holding their bond until maturity typically don’t need to worry about the movement of bond prices on the secondary market as they will be repaid their principal in full at maturity, barring a default. But for those looking to sell their securities sooner, an understanding of what drives bond pricing and yields is essential.
- The price of a bond relative to yield is key to understanding how a bond is valued. Essentially, the price of a bond goes up and down depending on the value of the income provided by its coupon/interest payments relative to broader interest rates.
- Owning a bond is essentially like possessing a stream of future cash payments. Those cash payments are usually made in the form of periodic interest payments and the return of principal when the bond matures.
- Bond prices and interest rates have an inverse relationship. When interest rates rise, newly issued bonds offer higher yields, making existing lower-yielding bonds less attractive, which decreases their prices.
We should also discuss bonds as a hedge for deflation (since inflation is a killer for bonds long-term). When there’s inflation, your bond income is worth less over time, but in a deflationary environment, they’re actually worth more. So, some investors might own bonds as a hedge for any recession.
However when it comes to owning fixed income I believe these three (3) key reasons come to mind:
- Bonds can be used to support your investing behaviour – ride out stock market volatility – including being strategic to buy more stocks soon.
- Bonds can be used to rebalance your portfolio – helping you keep your portfolio aligned to your investing risk tolerance and therefore asset allocation (mix of stocks and bonds).
- Bonds can be used for spending purposes – where some fixed income is “king” for major, upcoming, near-term spending.
The main reason I would keep any bonds (and I still don’t have any right now) is if I was saving for a major purchase in a few years (e.g., secondary residence?). Then, I would like rely on some form of fixed income between now and then to help secure that purchase. Otherwise, an interest savings account in the short-term will do that.
Unless something drastically changes, I will continue to believe the main role of fixed income in your portfolio is essentially safety.
My plan is to hold a modest cash wedge as I enter semi-retirement and keep a strong bias to equities. I believe any cash needed in the short-term (0 months up to 1-year) for any spending should never be in stocks.
Cash or cash ETFs are preferred for any time horizon <1-year of spending.
In fact, any cash you need for the next year or so, may be best held in a savings account for ease of accessibility and liquidity.
I suspect once I’m semi-retired and working part-time in a few years, my cash position beyond 1-years’ worth of expenses could grow. I don’t know. Time will tell. I tell you when my risk tolerance changes on this site!
Some say how much you invest in stocks, bonds and/or cash might be the most important portfolio construction decision any investor ever makes.
Depending on your investment timeline, your need to take on investing risk for reward, and any need for near-term liquidity, you might not need any bonds in your portfolio right now.
Or maybe you do. 🙂
Thoughts on this take? Do you own bonds right now? If not, how are you managing your portfolio – are you using a mix of stocks, dividend stocks and cash or cash ETFs?
Mark Seed is a passionate DIY investor who lives in Ottawa. He invests in Canadian and U.S. dividend paying stocks and low-cost Exchange Traded Funds on his quest to own a $1 million portfolio for an early retirement. You can follow Mark’s insights and perspectives on investing, and much more, by visiting My Own Advisor. This blog originally appeared on his site Sept. 12, 2023 and is republished on the Hub with his permission.