What good are bonds?
Source: Credit Suisse
Since the beginning of the 20th century, stocks have returned almost 10% per year while bonds have returned about half that. Because of compounding, though, a dollar invested in equities from 1900 forward would now be worth more than 140 times what a dollar invested in bonds would. And this is only reasonable. The best you can do when you buy a typical bond is get your money back, with a little bit of interest. But some stocks offer significant returns – like Amazon or Apple – as they grow from obscurity to commercial dominance. As the economy grows, stocks grow.
So why bother to own bonds in a portfolio at all? Over the long term, any money allocated to bonds has been a drag on total portfolio performance. There are even periods when bonds haven’t done as well as cash or inflation, most notably in the early 1920’s and the mid and late 1970’s, when inflation was rising and bonds’ fixed payments weren’t keeping up with prices.
The answer lies not in the assets themselves but in our needs and plans. If we don’t need the money, then there isn’t any need for bonds in a portfolio. But most of us don’t have “forever” time horizons. We’re saving for retirement or for our kids’ education or to have a nest egg where the interest income can supplement our lifestyle. We certainly can’t wait 116 years to touch the money. Even colleges that have been around for centuries tap into their endowments every year.
Great Wave off Kanagawa. Source: Metropolitan Museum of Art
Bonds provide an island of stability in a sea of uncertainty. We don’t know the future. All we have are promises and intentions. Bonds are a senior, legal claim on cash flow. Some bonds are even secured by real estate. In case of bankruptcy, bonds get paid first. And bonds almost always come with a maturity date: you know when your money should be paid back. So it makes sense that, over time, bonds are less risky. But they also return less.
Equities represent intentions: management intends for their company to grow; directors intend to pay dividends; employees intend to do a good job. But there are no guarantees. Good companies can fall on hard times and have to cut their dividends. Good employees can be on the wrong side of a merger or corporate restructuring and lose their jobs. Good managers can still run afoul of fickle markets or politics or circumstances. So even the best companies can suffer. That’s why the residual claims – stocks – can be so volatile.
It’s easy to forget, when times are good, that we don’t know the future. A well-constructed portfolio should be able to provide enough cash, over a full market cycle, so investors don’t have to liquidate positions when the market is unfavorable. Because markets fluctuate. It’s what they do. And the surest way to convert a temporary fluctuation into a permanent loss is to sell out when it’s down. That’s why having a series of maturing bonds – a bond ladder – can help investors stay on course amid uncertain markets.
HMS Blonde by Robert Dampier. Public Domain. Source: Wikipedia
Bonds are ballast to a portfolio amid stormy circumstances. And if you don’t have enough ballast to stay on course, you’ll never reach your destination.
Douglas R. Tengdin, CFA