Video: Why bother with bonds?

From Bogleheads
Jump to: navigation, search

Many investors wonder: Why Bother With Bonds? Here are four short videos that address why CDs, bonds, and bond funds are critical to building an all-weather portfolio-even during low interest rates.

Why bonds: #1 because stocks are risky

Why Bother With Bonds? Because stocks are risky is the first of four short videos that address why CDs, bonds, and bond funds are critical to building an all-weather portfolio—even during low interest rates.


Watch The Video (3 minute 22 seconds):

Transcript

Hi everybody. Welcome to the video series about bonds. I’m Rick Van Ness. We’re a non-profit site to help you be a smart investor and use common sense to build an all-weather portfolio to finance your dreams.

So, Why Bother With Bonds? The first reason why owning some bonds is always important is because stocks are very risky. If we pay any attention to the news, then we know they are volatile. A good rule of thumb is that they could lose 50% of their value in any year. That year could be this year, or the first year after you retire—so they are risky in the short-term and the long-term as well.

Over the past two centuries, stocks have returned 7% per year above inflation—or a real return twice that of bonds. [1]

But doesn’t this chart just beg our very question: Why Bother With Bonds? One important time is: when you can be hurt by short-term volatility. The ratio of stocks to bonds is the most important lever you have to control your overall investment risk.

Bonds are risky too. Later we’ll see that bond values move opposite interest rates and sometimes don’t keep up with inflation. But keep this in perspective! They are an order of magnitude less volatile than stocks and we’ll learn how these risks can be managed.

Now it’s time for some fun. It’s simple. I’ll give you two facts. You choose the fact that is true. Here’s the first one: The longer you own stocks, the safer they become. The second one is: The longer you own bonds, the safer they become. It’s your turn now. Click on the one that is true.

( 10 SECOND COUNTDOWN )

  If we use volatility to measure safety, then this one is false. Stocks remain volatile every day of every year, including the day before you sell them 40 years from now. But this is an easy mistake to make because we often hear that “stocks held for decades rarely lose money”. That’s true too, but not losing the amount you originally invested becomes less important than not losing the value it grows to become—and that you come to rely on.

This is correct. These two choices get at a major difference. While buying stocks are buying ownership in companies—something you can keep forever; buying a bond is really just loaning your money for a specific period of time. The longer you own the bond, the closer you get to the maturity date, at which time you’ll get back the full value that you invested. The highest quality bonds are very safe with no surprises.

Later on we’ll look at CDs, bond funds, and other ways to own bonds that have some differences to be aware of. But next, we’ll look at how bonds can provide welcome ballast to stabilize your portfolio in a bad year.

Why bonds: #2 because bonds make stock market risk palatable

Why Bother With Bonds? Because bonds can make stock market risk more palatable is the second of four short videos that address why CDs, bonds, and bond funds are critical to building an all-weather portfolio—even during low interest rates.


Watch The Video (2 minutes 50 seconds):

Transcript

So, Why Bother With Bonds? We already saw that stocks are both attractive, but risky. A second reason to own some bonds is to make that stock market risk more palatable. An allocation to bonds moderates the short-term volatility of stocks.

Here an investor put $10,000 into the stock market and had a wild ride. Here’s how it felt. [2]

Too many panicked after the market tumbled and sold at a loss. Remember: newspapers, magazines, and television shows all amplify the hysteria that cause some to sell their stocks. That’s bad and might have been prevented if that investor owned a bigger allotment of high-quality bonds.

Here’s what happened to an equal investment in Treasury bonds over this same period. It did fine, but probably most important is if it kept that investor from panic selling during a bad year. Bonds give the risk-averse long-term investor the courage and confidence to “stay the course” when the market periodically tumbles.

Now it’s time for some fun. Here are two statements. You choose the one that is true.

First we have: “Bonds are the underwear in your portfolio.”

Next is: “Bonds are the jewelry in your portfolio.” Click on the one that is true...

( 10 SECOND COUNTDOWN )

Nah, no one is going to brag about their bonds at a party, although they might brag about some stock they got lucky with, or show-off their jewelry.

Correct! The full quote by Dr. William Bernstein is “Bonds are the underwear in your portfolio—unexciting and not much thought about, but select the wrong pair and you’ll be surprised at just how uncomfortable you are.” [3] Perfect! Because this episode is all about planning to take as much risk as you comfortably can, after considering your goals and circumstances, and then sticking with your plan no matter what happens in the stock market. Dr. Bernstein made this comment when addressing whether to buy bonds that will mature in the short-term or the long-term. But I also like it because it applies to choosing between high-quality bonds or yield-yield bonds. We’ll get to all that later.

But first, I have asserted that Bonds can be a very safe bet. Is that really true? That’s next.

Why bonds: #3 because bonds are a safe bet

Why Bother With Bonds? Bonds are safe bet is the third of four short videos that address why CDs, bonds, and bond funds are critical to building an all-weather portfolio—even during low interest rates.


Watch The Video (3 minutes 46 seconds):

Transcript

So, Why Bother With Bonds? The third reason is that bonds can be a safe bet. And by that I mean “no surprises”. With any bond or CD, you loan your money for a specific period of time in exchange for periodic interest payments on specific dates of fixed amounts. And then at the end of the term you get your full investment back. In some cases, this is all guaranteed by the government—that’s pretty safe.

What can go wrong? Well, you can get into trouble by chasing after high-yield bonds from companies with low credit ratings. These are called “junk bonds” and they tend to get in trouble at the same times the stock market does—the very time you most want some stability. You can also have a problem if you lock your money up for a long term and then need it before the bonds mature.   The strategy I like, is to choose a fund of high-quality bonds that add stability to your investment portfolio when the stock market plummets. The thinking behind this strategy is that you’ll get better overall return by taking your investment risk on the stock side of your portfolio.

Now it’s time for some fun. I’ll give you two facts. You choose the fact that is true.

Here’s the first one: If you hold a bond (or a CD) to maturity, you still have interest rate risk.

Next: US Treasury Bonds, or FDIC-insured CDs, are risk-free investments.

( 10 SECOND COUNTDOWN )

This one is false. These do have impeccable credit risk, meaning they will pay you exactly as agreed (all the interest payments and then you’ll get 100% of your invested principle), but they still have interest rate risk. Interest rate risk means the value of your bond changes when interest rates change. All bonds, including all CDs, have interest rate risk, which is why this first fact is true.

YES! This is true. But it confounds a lot of people how you can have any risk from changing interest rates if you get all your interest payments and then 100% of your invested principle on the dates promised.

Let’s look at a simple example to help you see this. Suppose you purchase two bonds. The first bond you purchase yields 5%. The next day, bad luck, interest rates rise 1% and you buy a second bond. At 6%, it’s worth $10 more at maturity. That makes Bond 1 instantly worth $9.43 less than what you paid and that grows to the $10 difference at maturity. [4]

Another way to look at it is: you would need to invest $9.43 at the new interest rate to be equal to the $10 additional that the second bond pays.

Yes, ALL bonds have interest rate risk. So how can that be a safe bet? Because there were no surprises. You got exactly what you expected, and what was promised, when you purchased each of these!

Later, we will show how to choose bonds that will protect yourself from both interest rate changes, and from inflation. But next we’re going to see the important bonus you get because bonds often YING when stocks YANG.

Why bonds: #4 because bonds add attractive diversity

Why Bother With Bonds? Bonds provide attractive diversity is the fourth of four short videos that address why CDs, bonds, and bond funds are critical to building an all-weather portfolio—even during low interest rates.


Watch The Video (5 minutes 24 seconds):

Transcript

So, Why Bother With Bonds? Our fourth reason is that bonds can be an attractive diversifier in your portfolio. Not only do bonds dilute the amount of the portfolio at risk in the stock market, but the portfolio is strengthened by bonds which are poorly correlated.

This has a magical benefit for you, but first let’s understand the concept. Correlation is a measure of whether stocks and bond prices move together, or independently from each other.   Ideally, we would find two investments that had attractive average returns, but where one had a good year exactly when the other had a bad one. On a scale of -1 to +1, these would be very negative, but unfortunately these only exist in our dreams.

Uncorrelated, or poorly correlated, means they are independent from each other. This is terrific.

Things that move in the same direction at the same time are positively correlated.

Now before we get to the magic I’ve promised, we need to introduce one more thing: we need a way to describe the volatility of these returns.

The average annual return is the expected value. It’s useful and valuable, but it doesn’t indicate volatility. So we use this measure called standard deviation to describe the distribution of returns. It simply means that the total return will be within one standard deviation in either direction, roughly 7 out of every 10 years—or in this case within the range from -10% to +30%. Further, it means that the total return will be within two standard deviations for 95 out of every 100 years. Now let’s put it all together.

To illustrate two perfectly correlated funds let’s combine the S&P500 fund from one company with the S&P500 fund from another. Presumably they are perfectly correlated and the combination is a weighted average.

Here’s the part that may blow your mind: a portfolio of assets that are not perfectly correlated always provides a better risk-return opportunity than the individual assets on their own.

For example, here we combine an equal amount of two funds with the same expected return and the same volatility that are completely uncorrelated, meaning the movements are completely independent and unaffected by each other. The standard deviation becomes less than the weighted average. The combination is better than the individual funds on their own. Wow, where do you find an uncorrelated fund like that? The short answer is: bonds. The longer answer includes a warning that the correlation of two assets depends on the time period they are compared.   Let’s look at some actual returns.

  • These three years stocks returns went down but bond returns went up.
  • These four years stocks went up and bonds went up too.
  • And for these years, corporate bonds moved in the same direction as stocks, but treasury bonds moved opposite.

The most useful correlation information comes from comparing asset classes over a long period of time. An important point I want you to take away is that U.S. Treasury bond returns have almost no correlation with stock returns adding valuable stability to an investment portfolio. Being uncorrelated (or, near zero) means their values move independently from each other—but that doesn’t preclude that sometimes they move in the same direction.

Now it’s time for some fun. I’ll give you two facts. You choose the fact that is true. Here’s one: High-yield bonds are less correlated with the stock market than US Treasury bonds. Here’s the other: Choosing stocks and bonds that are uncorrelated give investors a “free lunch”.

( 10 SECOND COUNTDOWN )

That’s ok, because I only made a brief comment on this. Junk bonds, or bonds issued by companies with poor credit ratings, are euphemistically called “high yield” bonds and are sold to investors chasing after the highest yield for their bond holdings. These are more positively correlated with the stock market, and often perform poorly at the very time you need their stability.

This is true. The overall net result is to get more return for the same amount of volatility, or risk. That’s the free lunch. While moving in opposite directions at the same time would be ideal; being uncorrelated, or even poorly correlated, is very good. This is why high quality bonds are an attractive diversifier.

Video production credits

These videos may be freely shared under the terms of this Creative Commons License.

The author, Rick Van Ness, uses short videos to promote the Bogleheads® Investment Philosophy on his YouTube channel (YouTube.com/FinancingLife101) and his website (FinancingLife.org).

References

  1. This chart was created by Professor Jeremy Siegel, Professor of Finance at the Wharton School of the University of Pennsylvania. Used with permission. John C. Bogle takes the nominal returns in this chart and converts them to real returns in Common Sense on Mutual Funds, 1999, page 8.
  2. Market data from Fidelity website.
  3. Dr. William Bernstein quote from What's the Proper Bond Duration for Your Portfolio?
  4. This particular example was originally presented by Allan Roth in his article for CBSNEWS.com, Bonds vs. Bond Funds? An Easy Choice!, December 14, 2009.