What to Do About Bonds?

By Rick Waechter, Founder and Justin May, Portfolio Manager

Bonds are in the news – and not in a good way. Plenty of commentators suggest bonds are not worth owning, or they carry a lot of risk.

Bonds have always been hard for many investors to understand, and for others, they will always be downright boring.

The goal of this post: to explain why we continue to believe bonds are worth owning, and to give you options for the kinds of bonds you could productively own.

Why Own Bonds

You own bonds for three reasons:

In a very bad stock market, they almost always hold their value. That gives you a source for spending to avoid selling stock at low prices. Bonds are like cash in that way.
In a volatile stock market, they provide a cushion so your portfolio won’t look so terrible. This serves an emotional need – and it’s critical if it helps you not panic and sell stock at just the wrong time.
Most of the time, they provide a reliable source of income. They are better than cash in that way.

The chart below looks at three terrible periods for the stock market, comparing the US market to high-quality bonds. The conclusion is clear: when you most need a cushion, bonds serve the purpose.

Growth of $1 in U.S. government bonds versus the S&P 500 during three major stock market declines

Some people argue there are other kinds of investments which provide a similar benefit to bonds when stocks fall. These supposed replacements include gold, cryptocurrency, hedge funds, and annuities. We disagree. The first two are highly speculative and have, in the past, declined by 50% in a short period. Not exactly a cushion. (See our blogs, here and here.) Hedge funds are anything but transparent, so it’s impossible to know what they will do, other than generate huge fees for the managers. Annuities? Their similarly high fees condemn you to returns unlikely to match inflation.

What Kind of Bonds Should I Own?

If you agree you need a bond cushion, what are the options?

Bond funds or bond ETFs. They benefit from diversification and, usually, very low fees. They are our preferred vehicle. They have been frustrating to own these past few years because as interest rates have risen, prices have fallen, making average all-in returns 0%, on average, over the last 5 years.
Bond ladders. Here’s an explanation of bond ladders from Schwab. They may feel better than bond funds because you will almost always get your money back at maturity. But over time, we expect performance of a bond ladder to be similar, or slightly worse than that of a bond fund.
Shorter-term bonds. The shorter the maturity, the lower the risk, and the lower the expected return. Compared to intermediate-term or long-term bonds, they are more “cushion-y”. We think almost everyone should have a portion of their bond allocation in shorter-term bonds.
Higher quality bonds. These can be US Treasury bonds or CDs which almost always come with an FDIC guarantee. Like shorter-term bonds, you are reducing both risk and expected return.

Our bottom line: almost all investors should own bonds. Figure out which vehicle(s), from those above, feels best to you. Tune out the media frenzy. And don’t fall prey to hucksters who tell you gold, or crypto, or hedge funds, or annuities, are superior. They are inevitably focused on their financial situation, not yours.