It’s a widely accepted rule that all financial investors should own some “investment grade” bonds in their portfolios. The idea is to diversify by owning something “safe” whose price moves in a different way to stocks and shares. So far so good. But investment grade bonds were in a bull (rising) market from 1981 to 2012. If we’re now in the early stages of a bear (falling) market for bonds does it really make sense to own them?
Talk to practically any mainstream financial advisor and they’ll tell you that you must have a “balanced portfolio” split between stocks and bonds. The recommended percentage split will vary depending on things like age and risk tolerance of the investor.
So some people will find themselves with say, 50% in bonds and 50% in stocks. Others will find themselves with more weighting one way or the other.
Once the target percentages are set in place then market price moves will take them away from target. So a portfolio that starts the year split 50:50 between stocks and bonds may end the year split 60:40 if stocks rise and bonds fall, or if stocks rise faster than bonds.
…they don’t tend to recommend large allocations to cash or gold, since they don’t earn so much money that way.
Most advisors will also recommend annual rebalancing back to the target allocations. This is reasonable advice, but it has the added advantage (for advisors and brokers) of generating trading commissions. For this reason they don’t tend to recommend large allocations to cash or gold, since they don’t earn so much money that way. (If you want to learn more about the tricks that brokers usually play on clients, please read chapter 5 (Beating the Brokers) of the Wealth Workout report that you can download for free here.)
Few brokers offer reasonably priced physical gold storage, and there is no charge for “buying” cash (although they do earn fat trading spreads converting cash balances between different currencies).
Notwithstanding the costs, this balanced portfolio approach been sound advice for decades, at least in developed countries. Both stocks and bonds have been in a generally rising trend over that time. But crucially, when stock markets crash there is a “flight to safety” which drives up the prices of good quality bonds.
So the idea is to provide price diversification in the portfolio during times of crisis, while owning two asset classes that are profitable in their own rights over the long run.
Although this strategy has been highly successful in past decades I have serious doubts that it will work in future. I’ll explain why in a minute. But first a re-cap on what bonds are.
Bonds, or “fixed income securities”, are nothing more than easily tradeable loans. A bond issuer, such as a government or corporation, can borrow money this way with a promise to pay regular fixed amounts of cash interest “coupons”, and with a repayment of the original loan amount, or principal, a certain number of years into the future.
Investors can buy the bonds when issued and trade them with each other. A bond issuer is simply a borrower and a bond owner is simply a lender. There are other kinds of bonds, but most bonds are of the fixed income variety, so I’ll concentrate on those. “Investment grade” bonds are the ones issued by the best quality borrowers. These are the borrowers that have the best ability to pay the interest coupons on time and repay the original loan amount in future.
These borrowers include governments of financially sound countries, or at least those perceived to be sound. Think USA, Germany, Switzerland, the UK and so on. They also include large, solid companies with low levels of debt relative to net assets, or high profits relative to interest payments (also known as high interest cover).
At the other end of the scale are junk, or “high yield”, bonds issued by flaky companies. In these cases there is a decent risk that they won’t be able to pay back the debt in future. These bonds are a different animal that almost all private investors should avoid, so in the interests of space I won’t go into details. When it comes to price diversification benefits it’s only the investment grade bonds that count.
A crucial point is that investment grade bonds are lower risk than shares. In the case of a government that borrows in its country’s own currency it can always raise taxes or print money to pay the interest or principal. So it’s unlikely to default on the debt (although the value could be inflated away).
In the case of a company that gets into trouble the bonds are “senior” to shares. This means if profits fall the company has to pay bond coupons before it pays share dividends. And if the company goes bust and is liquidated the shareholders will only get a share of what’s left if there’s anything left after bond creditors have been paid back in full.
Because bonds are usually lower risk, when there is bad economic news or a stock market crash their prices tend to rise as panicky investors seek their relative safety.
So far so good. But nowadays there’s a catch. Bond prices are high and bond yields are extremely low. The bond yield is the percentage return of the annual cash coupon interest in relation to the bond price. Since the amount of cash coupons are fixed when a bond is issued this means that as bond prices rise yields fall, and vice versa.
The lower yields go, and the longer they’ve been trending in that direction, the more likely it is that the trend will reverse at some point. And when yields rise it means that bond prices will fall.
Below is a chart of 10-year maturity US treasury bond yields from early 1962 to the present day. There was a two decade secular bear market (falling prices) until 1981 followed by a three decade secular bull market until 2012. In that year yields reached their lowest level ever.
Of course yields could fall back to 2012 levels in another market crisis. But it seems to me that the larger risk is of yields rising to a point where bond investors can make a return again, after inflation and taxes.
10-year Treasury, 1/2/1962 – 7/11/2014
Given current low yields investment grade bonds are described by many as “return-free risk”. For example a US treasury bond that matures in five years currently has a yield of just 1.6%. But even official (as in, understated) US CPI inflation rose 2% in the year to July 2014. That means the real (inflation-adjusted) return on five year treasuries is a loss of 0.4% a year. It’s a bigger loss after taxes paid on the interest income.
So if bond yields start heading up in earnest, meaning prices will fall, the implication is that the balanced portfolio model may have reached the end of its shelf life for the foreseeable future. Bonds could still fulfil their role as portfolio diversifiers in times of stress, such as stock market crashes. If stocks fall hard then bond prices could rise in the short term.
But – and this is a big but – what if the bigger picture is that bonds are at the start of a multi-decade bear market, with rising yields and falling prices? Is the short term profit at times of stock market stress enough to make up for the longer term drip of steady losses from holding a large allocation to bonds? Would you really want 50% of your portfolio allocated to something that loses significant money most years as yields rise?
It’s impossible to say for certain whether the balanced portfolio is dead. I can’t predict the future any better than anyone else. Which is to say I can’t predict the future. If we fall into price deflation, or even just ultra low inflation, it’s possible that bond yields will fall further and extend the bond bull market for a few more years.
But to me the risks look asymmetrical. Bond are already a low return asset with a big risk that they could become loss making if prices fall as yields rise. For that reason I prefer to get my diversification in other ways. And that comes from cash and gold. (Interested in other ways you can diversify your portfolio? Please check our free Infographic 50 Ways to Invest)
Cash can be thought of as a bond that has instant maturity. The interest you receive on it is ultra low in developed country currencies such as euros, US dollars or yen. In fact, it will fail to match inflation (after taxes) even more badly than a longer dated bond.
But cash has a couple of important advantages.
First it’s virtually free to trade it, whereas bonds and bond funds attract brokerage commissions and fund management fees. In a low yield world this matters.
But its biggest advantage is that there is no price risk. A dollar remains a dollar, whatever happens in the stock or bond markets.
When stock markets are expensive, or you can’t find enough cheap ones around the world to stay sufficiently diversified, then put aside some cash.
So my view is that these days you should use cash and not bonds to diversify your stock market investments. When stock markets are expensive, or you can’t find enough cheap ones around the world to stay sufficiently diversified, then put aside some cash. The more scarce the cheap opportunities then the more cash you should put aside. And then every few years, just as they always have done, stock markets will fall sharply. After the dust has settled you can deploy your cash to scoop up large amounts of bargains.
Of course lots of you will no doubt want to point out to me that cash could also crash in a money printing world. And you’re right, although I often think this risk of a sudden break is overstated when it comes to big reserve and trade currencies such as the US dollar or euro. It’s more of a steady drip over a very long time.
But in any case, I know the risk is real. And that’s why you must also hold some gold. If the US dollar ever crashes in a ball of hyperinflationary flames there will be a flood of money into the yellow metal, and the price will spike.
So there you have it. Hedge your stocks with cash and hedge your cash with gold. You’ll remain diversified and you won’t have to worry about the dubious charms of the bond market.
I’ll leave you with one final thought. In every country where there is a long track record of data stocks (shares) have significantly outperformed bonds in the long run.
Below is a chart taken from the Credit Suisse Global Investment Returns Yearbook 2014, which analyses data going back to 1900 across 23 countries. This looks at US dollar returns for shares (called “equities” here), government bonds, and US bills (which are equivalent to cash) at the 23 country aggregate level.
Cumulative Real return 1900-2014The picture is similar for every single individual country. Stocks always outperform bonds and cash in the long run, although occasionally there are long periods where the opposite is true. One such period was from 2000 to 2013, which is another reason to think bonds will be poor performers in coming years.
Any serious investor that plans to invest for the long run, which I know includes all fellow OfWealthers, should always make it their business to have a large allocation of stocks in their portfolio. Preferably diversified across countries and sectors, and bought at low prices (low P/E ratios).
Stay tuned OfWealthers,