Individual Investors Should Stay Away from Bonds ... And Here's More Evidence Why That's the Case

Individual investors have long been encouraged by the investing gurus to 'play it safe' and own bonds as a high percentage of their 401(k), IRA or even taxable investment portfolios. That's been the conventional wisdom, but it's wisdom that I've rejected for the past several years.

The conventional advice wasn't wrong in a period of rising interest rates and inflation in the 1980s, 1990s, and even early in this century, but it is wrong now. Interest rates peaked in the late 1970s and have been on a consistently downward direction since then.

Now that they are at historic lows, they can't possibly fall much further. And that's the primary reason not to own either individual bonds or bond funds --- and especially bond funds. It's simple math.

As for me, I've been beating this 'stay away from bonds' drum for the past several years.  And now it seems that more of the so-called investing 'experts' are coming to that very same conclusion.

So let's see what one professional investor has to say in this week's cover story for Barron's. The article is titled  A New Approach to Bonds and is subtitled 'Bond funds tend to hold their value -- unless rates are rising. Is it time to dump yours?:

"Robert Johnson has spent most of his career studying and teaching modern portfolio theory. So it may come as a surprise to some that Johnson, 57, has not a penny of his portfolio in bonds.

 

“The absolute best-case scenario for bond investors is that rates remain low in the near future, which means your best hope is the status quo with no upside,” says Johnson, president and CEO of the American College of Financial Services. “If you lock in bonds at these levels, you’re locking in a purchasing-power loss.”

 

Not long ago, the notion of a no-bond portfolio would have seemed crazy. But what’s really crazy, says Johnson and many of his peers, is clinging to the conventional wisdom. “What are bonds supposed to do? They’re supposed to preserve wealth, provide periodic cash flow, and hopefully some price appreciation,” he says. At the moment, however, they aren’t offering much in the way of income, and there is a real possibility that investors could lose money.                        

Although the bond market is anything but simple, the math is. The bull market for bonds began in September 1981, when the yield on the 10-year Treasury peaked at 15.84%. Over the past three decades, yields across the board have steadily fallen, with the bellwether 10-year dipping as low as 1.63% in May 2013. Recently it has hovered around 2.3%. As yields have fallen, bond prices have gone up, and up, and up.

 

That worries Johnson, and it’s the reason that Warren Buffett declared, in 2012, that bonds should come with a warning label. When interest rates do finally swing the other direction, investors will most likely flock to newer, higher-yielding bonds, and the prices of today’s bonds will decline, perhaps precipitously.

Investors who own individual bonds and hold them to maturity are insulated, of course; barring a default, they’ll still get their principal and interest.

Bond mutual funds and exchange-traded funds are a different story. These funds, by and large, don’t aim to hold bonds to maturity, and even if they did, the strategy works only if investors stay put. If fund investors run for the exit, managers have no choice but to sell into a declining market.

That exit may be already starting. In the first five months of the year, investors put more than $75 billion into taxable and municipal-bond funds, according to Lipper. But in June, the trend turned, with investors withdrawing a net $17 billion. If that presages a bigger exit, bond funds could fall sharply.

             

“This might be blasphemy, but if you’re worried about rising rates, you’re almost better sitting on cash than going into a bond fund,” says Shari Burns, managing director of United Capital Financial Advisors in Seattle. . . .

THAT RISK DOESN’T get talked about very often, and most investors approach retirement with a big stake in bond funds. “A lot of individual investors don’t understand that they could actually lose money in their bond funds,” says Raj Sharma, a managing director of Merrill Lynch Private Banking and Investment Group in Boston....

Mathematically, a higher allocation to stocks makes sense, says Cohen, who is manager of the ClearBridge Dividend Strategy fund. “But most people don’t have the temperament to have all their money in stocks,” he says.

NO DOUBT, ONE OF THE BIG arguments for sticking with bonds is that they are still the best insurance policy against stock market declines. “People have a short-term memory of the role fixed-income plays,” says Jay Sommariva, a senior portfolio manager at Fort Pitt Capital Group in Pittsburgh. Case in point, he says, is 2008, when “once the dust settled, the bonds that didn’t have credit problems bounced back before stocks.”

Even so, investors could be in for a rude awakening. The bond market has, for the past three decades, been exceptionally generous to investors. “Because rates have been falling, every time an investor wanted to get more conservative, there was very little to give up [in return],” says David Lafferty, chief market strategist of Natixis Global Asset Management in Boston. “Bonds do still play a role, but investors need to reset their expectations.”. . .

 

There was a time when bonds could do it all—provide stability, income, and capital appreciation. Those days are over. Now, investors need to pick their focus. And that focus should be determined by an investor’s need, rather than a hackneyed asset-allocation plan that decrees 55-year-olds dump 55% of their assets into bonds.

But even if the conventional wisdom no longer holds true, the advice is very much the same as it ever was: Know thyself as an investor, and construct a plan that suits your timeline and temperament. That is how Johnson arrived at his no-bond portfolio. “There is a willingness and an ability to take on risk, and I have both,” says Johnson. “I’m gainfully employed and have no plans to retire any time soon. But there are people in the same exact situation who couldn’t sleep at night if the stock market fell 20%.”

MOST INVESTORS NEED some form of stability, but that can mean many different things. For some it’s psychological: When the stock market hits the skids, it’s what keeps them from making short-sighted decisions. For others, stability has practical implications: They need a certain amount of money at the ready, whether for an impending expense, or in the case of retirees, to cover living expenses. . . .

If your need for stability is attached to a specific goal or need, such as a tuition bill or down payment—and you need to access those funds within the next decade—you’ll want to take a different approach. If your time horizon is short, say one-to-two years, it’s probably best to stick with cash, since even short-term bond funds could experience losses in the near term.

RETIREES LOOKING for a place to stash five or 10 years’ worth of living expenses, though, run the risk of inflation outpacing the paltry returns on cash. What about hiding out in cash until rates go up? “That would be the right strategy if rates move up quickly,” says Leech. Of course, timing the bond market is even more difficult than timing the stock market. “Plenty of people have tried to capture interest rates and failed,” Leech adds. . . .

FOR YOUNGER INVESTORS—and older ones, too—there is an appeal in the keep-it-simple approach of taking some bond risk off the table. Hold more cash or cash-equivalents (for example, ultrashort-term bond funds) than you would typically, and keep the rest in a diversified portfolio of stocks, including dividend payers.

 

“You’re getting a bit of a yield—and it’s commensurate with bonds—yet over the long term, the values of those securities will likely increase and so too should the dividends,” says Johnson. Indeed, the current dividend yield on the Standard & Poor’s 500 is 2%, and companies ranging from Johnson & Johnson to Wal-Mart Stores have consistently raised their dividends for decades.
 

This isn’t to say that dividend-paying stocks aren’t vulnerable to rising rates. Any income-producing asset could lose value if higher-yielding alternatives come on the scene. Still, the prices and dividends of these stocks are more closely linked to their own prospects.
 

Jeremy Kisner, a certified financial planner with Surevest Wealth Management in Phoenix, notes that dividend growers may do better than those focusing on the absolute highest-dividend stocks. More importantly, consider the effects of rising rates on the underlying businesses, for better or worse. Rising rates bode well for most financial stocks, says Kisner."
 

Summing Up

To repeat, I've been advocating staying away from bonds for several years now.

The 'experts' finally seem to be taking that same position.

Although usually it makes me nervous when the 'experts' share my opinion on investing, this time I'm not concerned --- not at all.

And that's because I own neither any individual bonds nor any bond funds in my personal all stock and some cash portfolio.

And I very much intend to keep following that investment approach.

That's my take.

Thanks. Bob.