The Golden Rule in financial planning is 60/40. If you saved $10,000 your financial adviser would tell you that $6,000 should be held in stocks. And that you should buy bonds with the remaining $4,000. The rationale is that stocks are known to be volatile and risky. While bonds are considered to be safe and sound and do not fluctuate in value as much.
The Darwinian rule that only the fittest survive does not seem to apply in the world of bonds. You would think that over time, only the best - and safest - bonds would be available to purchase. But as a matter of fact, the types of bonds an investor can now buy nowadays are fulls of risks.
A few examples: there are bonds backed by the full faith and credit of the U.S. government; bonds backed by corporations, both domestic and international; bonds whose payments are tied to U.S. inflation, known an TIPS; bonds backed by the full faith and credit of foreign governments; bonds backed by promises of local municipalities; bonds backed by residential mortgages; And junk bonds, which are bonds that pay a higher yield due to a higher probability of default.
Great investors do buy bonds. Bill Gross, who co-founded Pacific Investment Management Corporation and ran their $270 billion Total Return Fund, is considered a legendary bond investor.
In 1984, Warren Buffett bought large quantities of Washington Public Power Supply System bonds. He noted: “
Charlie and I judged the risks at the time we purchased the bonds, and at the prices Berkshire paid, which were much lower than present prices, to be considerably more than compensated for the prospects of profit."
Yet holding bonds pose risks. First, at time of duress - think the Great Recession - it becomes difficult to sell bonds. This is known as liquidity risk.
Second, while as a bond holder you are promised a certain rate of return, if interest rates increase, and similar bonds in terms of credit and risk offer a higher rate of return, the value of the bond you hold is reduced. This sensitivity of the bond's value to the interest rate environment is known as duration risk.
Third, purchasing one bond, backed by just one corporation, will expose you to the financial health of the company. Read: if the operating performance of the corporation deteriorates, you may not get your payments as promised. This is known as concentration risk.
Mr. Market solution to these three risks has been the advent of exchange traded funds (ETFs). In a conference I attended last week in Newport Beach, I learned that there are now over 380 bond ETFs; effectively, these are investment vehicles that buy bonds and pay you, the investor, a coupon payment. There are ETFs that track inflation, such as Schwab U.S. TIPS ETF (traded under SCHP) and municipal bond ETFs, such as SPDR Barclays Municipal Bond ETF (traded under TFI). The list goes on and on.
But I never bought a bond ETF nor do I plan to own one. Nassim Taleb, the investment philosopher, once said that the greatest risk is the one we don’t understand. And I certainly cannot understand the value of the bonds owed by any of the varying ETFs.
Take, for example, PIMCO Total Return ETF, traded under the symbol BOND. The “sensible income-focused strategy paired with world-class resources” as described by Morningstar the ETF, owns U.S. Government bonds (25% of the fund), Mortgages (60%) of the fund and investment grade credit bonds. And if you had invested $10,000 in BOND in February 2012 it would now be worth $12,602, a pittance of return at 3.36%.
But even with an inferior yield for bond investing, for some investors buying bonds is important. Take banks or insurance companies, for example. These financial services entities are required by law to hold bonds and are discouraged from purchasing the stock of publicly traded companies. A second example would be a pension fund that expects to pay out, in 3 years, retirement benefits and would need to buy a bond that will expire in 3 years.
In the Intelligent Investor, Benjamin Graham devotes much space to historical patterns of financial markets. "To invest intelligently in securities on should be forearmed with an adequate knowledge of how the various types of bonds and stocks have actually behaved under varying conditons - some of which, at least, one is likely to meet again in one's own experience."
And there is simply insufficient data to understand how bond ETFs behaved in different market cycles.
History shows that the return from holding bonds is less than the return from holding stocks. In Jeremey Siegel’s Stocks for the Long Run, he provides data that supports the prior statement. If you had invested $100 in 1802, you would have $704,997 in 2002. Compare that to the same investment in bonds and you end would have ended up with a pittance of $1,778 in bonds.
The 200-year annualized return from stocks was 6.6%, and for bonds it was merely 3.6%. This is the magic of compounding interest.
More important than choosing between stocks and bonds and the allocation between the two assets is that you follow Socrates’ advise to know thyself. Not very different from a scientist, a successful investor constantly asks: “Why? Why am I buying bonds, and will my rationale hold in good and in bad times?”