Author Topic: Why invest in bonds at all?  (Read 6083 times)

rudged

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Why invest in bonds at all?
« on: February 04, 2018, 09:48:07 AM »
There used to be a rule of thumb that you should split your savings between equities and more secure assets such as bonds, and that the proper allocation of stocks should be 120 minus your age, the presumption being that when you are retired and no longer in the accumulation phase, you need to guard against market volatility. Given the relatively long time that individuals preparing for (or are in) early retirement have before them (and the fact that most of us are investing in highly diversified stock indices), this seems really odd. Perhaps someone can talk me down.

BTDretire

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Re: Why invest in bonds at all?
« Reply #1 on: February 04, 2018, 10:06:20 AM »
 I'm at the age where 'they' say I should have a decent % in bonds, but this is a terrible time to be in bonds.
The FED has made it clear that they are raising interest rates, bonds a very likely to lose value in
a rising rate environment.
 So what to do to provide some diversity away from stocks?
 I don't know if there is a good answer, for myself I'm putting some money it REIT preferred stocks,
While they pay higher rates than bonds, they are still a stock subject to ups and downs, but IF the company
does NOT go bankrupt you will get your dividend payment until the preferred is called at it's $25 price.
 It does not have to called, it can continue to pay the dividend.
 If there is a company problem the regular stock dividend will need to be cut to zero before they can
stop the preferred dividend, and you want cumulative preferreds, meaning if the stop paying the dividend
it accumulated until they are back on their feet.

damyst

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Re: Why invest in bonds at all?
« Reply #2 on: February 04, 2018, 01:07:46 PM »

Indexer

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Re: Why invest in bonds at all?
« Reply #3 on: February 04, 2018, 01:14:24 PM »
During accumulation, not much reason.

Right before and right after retirement you need to worry about sequence of return risk.

100 % stock portfolio: Average returns = 10%. Worst year performance: -43%.

What if that worst year is the year you retire, what if the following year is also bad, and what if it takes several years to recover. Multiple times in history the stock market has been down more than 50%, and on multiple occasions we've experienced negative returns over 10 years. If you started with a 4% withdrawal rate and the market tanks 50% you now have an 8% withdrawal rate, and unless the market turns around quick your balance will keep dropping. At that point the market is unlikely recover fast enough at that point to cover your withdrawals for 30+ years.

Or...

60% stock, 40% bond portfolio. Average returns = 8.8%. Worst year performance: -26%.

Historically you are giving up 1-1.5% return per year, but you significantly cut your worst year performance. Here is another way to look at it. If you retire using the 4% rule then you have 25X expenses at retirement. With a 60/40 portfolio that means you have 15X expenses in stocks and 10X expenses in bonds. If the stock market crashes the same year you retire then you could live off your bonds for 10 years, not counting dividends and interest income. That gives the market plenty of time to recover. You could also rebalance from bonds into stocks.

Side note: 100% stocks and a 60/40 are unlikely to average those same returns over the next 10 years, but that's another conversation.

Quote
I'm at the age where 'they' say I should have a decent % in bonds, but this is a terrible time to be in bonds.
The FED has made it clear that they are raising interest rates, bonds a very likely to lose value in
a rising rate environment.

From 2003 to 2006 the Fed funds rate went from 1.00% to 5.25%. Vanguard Total bond fund still managed to have positive returns every year. Why? Well because a well diversified bond portfolio doesn't fluctuate nearly as much with interest rates as people like to make it seem. Bond prices were down 2% over a year isn't a story worth panicking about, but the news needs to have something to panic about so they go on and on about the impending bond market crash. Sure bonds fluctuates some with interest rates, but it's nothing in comparison to stock market volatility. Total bond has only had one year with a negative return in over 15 years and that was 2013. 2013 was another year people were certain interest rates were going to shoot up because the of the Fed. Total bond was down 2.15%, not exactly a crisis. Turns out the markets were completely wrong, and 2014 ended up being a great year to be in bonds when people realized interest rates were barely moving. Predicting interest rates is about as hard as predicting the stock market.


Disclaimer: there is a certain amount of discipline that comes with being 100% stocks. If you don't have it then being 100% stocks could be bad for your wealth.

rudged

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Re: Why invest in bonds at all?
« Reply #4 on: February 05, 2018, 09:04:15 AM »
Thanks for your lengthy reply. I wrote a related question to J. L. Collins (The Simple Path to Wealth) several months ago, namely whether his suggestion that you start to invest in bonds when you are no longer in the accumulation phase (to smooth out market volatility) might depend upon the amount of your withdrawal. In other words, it makes sense to have a stake in bonds if you have a 4% withdrawal rate; much less sense if you don't plan to withdraw at all. He suggested the sweet spot where you could continue to have it all invested in stocks might be a 2% withdrawal rate.

frugaliknowit

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Re: Why invest in bonds at all?
« Reply #5 on: February 05, 2018, 09:16:48 AM »
I used to ask myself the same question.  1999-2009 the stock market was negative.

Check out this podcast:  https://paulmerriman.com/what-to-do-about-bonds/

alanB

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Re: Why invest in bonds at all?
« Reply #6 on: February 05, 2018, 10:46:04 AM »
Not all bonds are created equal.

There used to be the common wisdom that high-yield corporate bonds were a bad investment, too risky and too hard to diversify.  Hence the name "junk" bonds.  Now a junk bond fund doesn't look so bad.

Municipal bonds might be attractive because of the tax-savings.  Plus it gives you that sense of civic pride when you loan money to your local state rather than into the abyss of the Treasury.

If you own a house you might be better off paying down your mortgage vs. having a large bond allocation.  Here is a relevant article: https://www.personalcapital.com/blog/whitepapers/your-mortgage-and-your-bonds/ 

Additionally, you can reduce your sequence of returns risk by refinancing or paying off your mortgage prior to retiring.  If you are not worried about sequence of returns then 100% stocks might work for you.  In the past there were higher return portfolios than 100% stocks with less risk, but no one knows what the future will hold!!

spokey doke

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Re: Why invest in bonds at all?
« Reply #7 on: February 05, 2018, 10:58:19 AM »
There are many, many recent threads discussing this issue, with some very insightful commentary, here:

https://www.bogleheads.org/forum/viewforum.php?f=10

Car Jack

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Re: Why invest in bonds at all?
« Reply #8 on: February 05, 2018, 11:56:24 AM »
As you're older and closer to retirement, it gets much clearer.  I'm not the typical 23 year old here who's looking at decades before I call it quits.  I turned 61 last week and have somewhere in the 1-3 years left before I retire.  Let's say it's 1 year and the landslide that started in stocks last week becomes a 2008 and stocks drop 50%.  If it stays there a few years, and I'm all in stocks, I'm screwed and I no longer am retiring in 1-3 years....I'm waiting until the recovery comes in.  Maybe that's 5 years.  At my age, I'm not getting a do over to retire.  Worse still, because my life expectancy is shorter than average, I die before being able to quit work.  Wouldn't that be tragic?

So I'm 50/50 stock/bond with a good amount of the bonds in US Savings bonds.  Even if that 50% crash comes, I'm only down 25% and I have saved enough that I could still retire.


daverobev

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Re: Why invest in bonds at all?
« Reply #9 on: February 05, 2018, 04:47:55 PM »
As you're older and closer to retirement, it gets much clearer.  I'm not the typical 23 year old here who's looking at decades before I call it quits.  I turned 61 last week and have somewhere in the 1-3 years left before I retire.  Let's say it's 1 year and the landslide that started in stocks last week becomes a 2008 and stocks drop 50%.  If it stays there a few years, and I'm all in stocks, I'm screwed and I no longer am retiring in 1-3 years....I'm waiting until the recovery comes in.  Maybe that's 5 years.  At my age, I'm not getting a do over to retire.  Worse still, because my life expectancy is shorter than average, I die before being able to quit work.  Wouldn't that be tragic?

So I'm 50/50 stock/bond with a good amount of the bonds in US Savings bonds.  Even if that 50% crash comes, I'm only down 25% and I have saved enough that I could still retire.

Well, the counter is that presumably you have some kind of government income soon.

I think the bond thing is MORE pressing for early retirees than 'traditional' ones. That, of course, is assuming that whatever government pension scheme pays enough of a percentage of your base living costs, I suppose.

Radagast

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Re: Why invest in bonds at all?
« Reply #10 on: February 05, 2018, 08:35:21 PM »
Answer 1: There is no guarantee stocks will give you what you want in the time period you want it. Bonds either, but they give you another chance at it. A much larger chance over short periods.
Answer 2: Psychology.
Answer 3: The highest historically successful withdrawal rates all included bonds in some fashion or another.

Details:
When you are just starting there is no real reason, your best bet is almost certainly all stocks. Risk and return are the same thing when you are first starting. As you use up more human capital risk starts to separate from return. If the risk shows up you may not be able to get your return fast enough to avoid extra work or cutbacks.

I always recommend 10%-40% bonds, noting that the center of the range is 25%. I would say you should count cash, emergency funds, NPV of social security and pensions, etc. into this, which means in practice it is pretty easy to fall into this range. I've been about 20% bonds the entire time I've been investing, even though at first I in theory had 0% and now in theory have about 10%.

Another reason is rebalancing. When stocks go down bonds are often flat or up, which allows you to sell them to buy stocks on sale. Over the very long term stocks should return more than bonds, so rebalancing back into bonds is not really a great strategy for 40-year+ spans. Some people have recently been suggesting a "reverse glide path" or "bond tent" which basically means you start with 10% bonds 5 years before retirement, then go up to 40% at retirement, and then glide back to 10% over the next 10 years (actually nobody recommends that exact method, it's just an example.

120 - age in bonds and other "age in bonds" strategies are kinda dumb and based on nothing whatsoever.

Tyler

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Re: Why invest in bonds at all?
« Reply #11 on: February 05, 2018, 10:10:43 PM »
This question is pretty common and is a natural reaction to a strong stock market.  But if you look at the data in both good times and bad, diverse portfolios including bonds and other assets tend to be more dependable, efficient, and sustainable for most investors.  And for retirees, they often have higher withdrawal rates as well.  So IMHO, smart asset allocation that diversifies beyond stocks can be a powerful tool for a prospective early retiree.
« Last Edit: February 05, 2018, 10:19:07 PM by Tyler »

Abe

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Re: Why invest in bonds at all?
« Reply #12 on: February 05, 2018, 10:13:20 PM »
For rebalancing while earning - is it better to buy more of whatever investment type is down (bond, stock, REIT, etc) rather than actually selling whichever is up to finance the purchase? That's what I've been doing. Intuitively I'd guess it is, but wanted to hear your opinions. Also, I was thinking of allocation in terms of what is the total amount of bonds I would need to have dividends that would fund basic expenses (assuming house is paid off).

Example:
- Goal is $35k for basic expenses
- VBTLX income return averaged 3.75% over last 15 years
- Need $1m invested, if I include the above return that's $50k over 15 years (retirement target)
- Current savings around $100k/yr

Maybe I should put the first $80k of annual gains from stocks into the bond funds for rebalancing? I'd think of it as an "overflowing pot of money" way of saving. That seems better than putting the first $80k of annual savings into bonds, then put $20k into stocks, then having to rebalance stocks into bonds at the end of the year to keep the same allocation goal. What is your opinions on this?

Mighty-Dollar

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Re: Why invest in bonds at all?
« Reply #13 on: February 06, 2018, 12:04:08 AM »
There used to be a rule of thumb that you should split your savings between equities and more secure assets such as bonds, and that the proper allocation of stocks should be 120 minus your age, the presumption being that when you are retired and no longer in the accumulation phase, you need to guard against market volatility. Given the relatively long time that individuals preparing for (or are in) early retirement have before them (and the fact that most of us are investing in highly diversified stock indices), this seems really odd. Perhaps someone can talk me down.
The reason why you don't want to ignore bonds is what they call the "sequence of returns". In your early years of retirement you cannot afford to take a big hit to your portfolio. Stocks are volatile. What if stocks crash and all of a sudden you're taking out perhaps 7% per year instead of 4% per year with 30 - 35 years of retirement left to go. You might run out of money, especially when coupled with high inflation.

alanB

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Re: Why invest in bonds at all?
« Reply #14 on: February 06, 2018, 07:34:29 AM »
For rebalancing while earning - is it better to buy more of whatever investment type is down (bond, stock, REIT, etc) rather than actually selling whichever is up to finance the purchase? That's what I've been doing. Intuitively I'd guess it is, but wanted to hear your opinions. Also, I was thinking of allocation in terms of what is the total amount of bonds I would need to have dividends that would fund basic expenses (assuming house is paid off).

Example:
- Goal is $35k for basic expenses
- VBTLX income return averaged 3.75% over last 15 years
- Need $1m invested, if I include the above return that's $50k over 15 years (retirement target)
- Current savings around $100k/yr

Maybe I should put the first $80k of annual gains from stocks into the bond funds for rebalancing? I'd think of it as an "overflowing pot of money" way of saving. That seems better than putting the first $80k of annual savings into bonds, then put $20k into stocks, then having to rebalance stocks into bonds at the end of the year to keep the same allocation goal. What is your opinions on this?

Just keep buying whatever is low, yes, that is what I do.  Try not to sell within taxable accounts to avoid capital gains.  Rebalance by selling within non-taxable accounts if possible.  Your "overflowing pot of money" strategy is going to be killed by capital gains if it is in a taxable account, especially if they are short-term. 

Also your AA sounds crazy conservative... why do you think it will take 15 years to reach $1MM at savings rate 100k/yr and $35 in expenses?  See: http://networthify.com/calculator/earlyretirement?income=135000&initialBalance=0&expenses=35000&annualPct=5&withdrawalRate=4 Are you saying that just the bond allocation is going to cover all of your expenses? 

boarder42

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Re: Why invest in bonds at all?
« Reply #15 on: February 06, 2018, 07:44:31 AM »
I'm currently going down a path of replacing bonds with REITs - there is a post on the 150 year history of everything - and it makes a strong case for a very large holding in a diversified REIT index.  i think my AA for when i'm FIREd may switch to 50/50 REIT to equity or will have REITs replace bonds and represent 10-20% of my total holdings.

basically RE has performed basically at the same return as equities with much less volatility and with very little correlation to equities.  so there is a strong case for no bonds at all and an increase in REIT and small cap exposure both pre FIRE an post FIRE IMO.

Abe

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Re: Why invest in bonds at all?
« Reply #16 on: February 06, 2018, 07:47:26 PM »
Yeah that is super conservative - Iím planning on 15 years of work and this is just to cover basic expenses. I like the idea of having a solid foundation despite the extra work time. If the job starts to suck Iíll just exchange for stocks and get to retirement early. The rest our retirement income will come from stocks were investing in concurrently with the bond funds. We also want to leave an endowment for scholarships so need to work a few years more to fund that. Good point about the capital gains - My wife and I both have two retirement accounts so we have $72k thatís tax deferred per year. I guess in that case itís better to just put in money from our annual savings into those accounts and rebalance annually, and our whatever else is left into a taxable account and not worry as much about shifts in AA to avoid taxes on rebalancing. Itís annoying having 5 accounts, but thatís a total 1% first-world problem so wonít complain.
« Last Edit: February 06, 2018, 07:56:09 PM by Abe »

retireatbirth

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Re: Why invest in bonds at all?
« Reply #17 on: February 06, 2018, 07:58:07 PM »
I didn't care about bonds until about $300k. Most people start to want to reduce their volatility at some point.

anisotropy

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Re: Why invest in bonds at all?
« Reply #18 on: February 06, 2018, 08:32:24 PM »
It is my observation that people advocating 100% equity tend to over-estimate their risk tolerance and/or are inexperienced when it comes to bear market. If you thought the last few days was bad, then it might be useful to have some bond allocation.  Having some bond also dampens the "damage", we have to keep in mind that the tranquil market condition we had become accustomed to is not how things usually are, just ask those poor XIV "investors".

To put things into perspective, s&p so far had a 8% drop since Jan26, with some bonds you could easily reduce it to 6%. For a one million dollar portfolio, that's 20k and goes up from there.

Abe

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Re: Why invest in bonds at all?
« Reply #19 on: February 06, 2018, 08:46:09 PM »
Yep, even with 20% bonds it was only a 4.5% drop. I started adding bond funds in around $300k also