Why Every Portfolio Needs Bonds

Back on March 25, I wrote a post called The Bond Dilemma that described how nervous fixed-income investors were in early 2010. The Bank of Canada had strongly suggested that it would raise interest rates later in the year, and I was receiving a number of emails from people who said it was foolhardy to invest in bonds, which seemed almost guaranteed to lose money.

The year isn’t over yet, but once again the conventional market predictions seem to be wrong. We did get two small interest rate hikes this year, and yet bonds have been one of the best-performing asset classes so far in 2010. While stocks in developed markets are treading water, bond index funds are up over 5%. They’re the only reason balanced investors have had positive year-to-date returns, despite all the forecasts about how bonds were certain to get killed.

Bonds have a reputation for being boring, even a bit stodgy. Yet the performance of Canadian fixed income has been excellent for three decades. In the 1980s, steadily falling interest rates created a huge bull market for bonds. During the 1990s, when US stocks were shooting the lights out and getting all the attention, Canadian bonds averaged returns over 10%. Then, through the terrible 2000s, bonds gave investors annual returns around 6%, trailing Canadian equities by only 1% per year, and soundly thumping US and international stocks, which were negative for the decade.

Through it all, it sometimes seemed like bonds didn’t even show up on the radar. When things hit the fan in 2008, how many market commentators proclaimed asset allocation dead because “everything went down together”? They apparently didn’t notice that a conventional balanced portfolio — such as the Global Couch Potato — includes 40% bonds, and the DEX Universe Bond Index was up 6.4% in 2008. Government of Canada bonds topped 11% on the year. Investors with that traditional 40% bond allocation enjoyed a much softer landing: they would have lost about half as much as an all-equity portfolio.

Perhaps most importantly, bonds have delivered these solid returns with a fraction of the volatility of stocks. Since 1980, the broad Canadian bond market has had just two negative years: a loss of –4.3% in 1994, and an even milder –1.1% drop in 1999.

The message here is simple: bonds should be part of just about every portfolio. While it might be reasonable for a very young investor to allocate 100% to equities, I’m not convinced that’s the best strategy. The biggest obstacle in investing is human psychology: we all hate to lose money, and a novice who experiences big losses in an all-equity portfolio in her 20s may abandon the markets altogether. Indeed, that’s exactly what seems to be happening to young people who got shredded during the last decade. USA Today recently reported that the investors most likely to avoid stocks today are Generation Y (aged 18 to 28) and Generation X (aged 29 to 45).

As an asset class, investment-grade bonds — especially government bonds — have the lowest correlation to equities, especially in Canada. (Commodities have historically had a low correlation with stocks in the US, but that’s much less true in our resource-based market.) That means they offer a tremendous diversification benefit in a portfolio, smoothing out the volatility that causes so many investors anguish. Maybe someday they’ll get the respect they deserve.

Later this week, I’ll look at Canadian bond index funds, comparing their fees and performance over the past decade.

21 Responses to Why Every Portfolio Needs Bonds

  1. Financial Cents September 6, 2010 at 11:21 am #

    Excellent post.

    I’ve got about 30% of my RRSP in XBB…and you’re right, past and recent market turbulence has largely been softened because of it. Personally, I like boring. Just like Canadian bank stocks on the equity side are “boring” and largely predictable, so is XBB on the fixed-income side. Maybe it’s because I enjoy a good night’s sleep. 🙂

    Cheers,
    Mark

  2. Mark September 6, 2010 at 11:33 am #

    Interesting, I have been considering switching to 100% equities as a young investor (currently 75%), I might have to reconsider now.

    Can you give a link that shows the DEX Universe Bond Index historical chart? I can’t seem to find one on that website that goes back beyond a couple of years and the iShares/TD Bond Index only goes back about 10-13 years?

    Thanks,
    Mark

  3. larry macdonald September 6, 2010 at 12:43 pm #

    Another interesting angle to consider is smoothing volatility in returns from one’s asset of “human capital” and correlations with other assets. If you are a professor with tenure, you may not need a high allocation to bonds; if you are an investment banker, you may want to have a lot of bonds.

  4. Canadian Couch Potato September 6, 2010 at 12:44 pm #

    @Mark: The best long-term data I could find on Canadian bond returns is the excellent spreadsheet compiled by Norbert Schlenker of Libra Investment Management. You can find it here:
    http://www.libra-investments.com/re01.htm

    You can also visit http://www.iShares.ca and click “Index Returns Chart.” Select the DEX Universe Bond Index and then click “Download Selection” to get an Excel chart of the index returns: monthly for the current year, and annually going back five years.

  5. Think Dividends September 6, 2010 at 10:14 pm #

    My strategy is to be 100% invested in dividend growth stocks. Some people will argue that my strategy is risky, but I disagree. For me risk isn’t defined by the volatility of my portfolio; Risk is not being able to keep up with inflation. With dividend growth my cash flow grows every year. That’s something that can’t be said about investing in fixed income. Bonds and GICs are great for short term savings, but they don’t create wealth, companies do. I’d rather own a boring company like Johnson & Johnson or Enbridge versus a government bond anyday.

  6. Canadian Couch Potato September 6, 2010 at 10:45 pm #

    @Think Dividends: If you have the stomach to endure volatility without panic-selling, then I would agree that dividend growth investing isn’t particularly risky.

    For the record, however, according to Schlenker’s data, linked above, the average real return (i.e. after inflation) delivered by Canadian bonds since 1982 was 7.4%. That was only marginally less than equities, including dividends. This is my point about bonds getting a bad rap: people lump them in with GICs, but they are a different asset class with historically much better performance.

  7. Mark September 7, 2010 at 1:11 am #

    It seems like most of the huge gains for bonds were in the 80’s (i.e. 35% gains in 1982), I wonder what brought this about and it is just an anomaly or something that can happen again in the future?

  8. Canadian Couch Potato September 7, 2010 at 8:27 am #

    @Mark: The huge gains in bonds in the 1980s were the result of falling interest rates. (Ask someone in their 60s if they remember paying 22% for a mortgage back then!) The overnight rate, currently 0.75%, was over 19% in 1980 and fell to less than 8% by 1987.

    That obviously cannot happen now, and no one should expect double-digit returns from bonds today. But remember, the 1980s also had double-digit inflation, whereas we are now enjoying a long period of low inflation, so real returns on bonds have still been in the 4% to 5% range for the last decade.

  9. Pacific September 7, 2010 at 6:26 pm #

    Excellent article!
    You could stress more about the advantage of tax treatment for Canadians on dividends on Canadian companies.

  10. WealthWebGuru September 9, 2010 at 12:04 pm #

    Thanks for the post. I’ve always favoured a conservative bent so some money in fixed income is wise advice. What about having GICs instead of bonds in fear of rising interest rates and also to remove role that psychology has on investor behavior when investments fluctuate (even in the bond market)?

  11. Canadian Couch Potato September 9, 2010 at 12:49 pm #

    @WealthWebGuru: Thanks for the comment, Jim. Personally, I see GICs as short-term instruments. In a long-term portfolio, a diversified bond ETF should provide higher returns with only moderately more risk. But you’re right, many investors like the fact that a GIC’s principal never declines, and there is some value in that.

  12. Rob VH September 20, 2010 at 2:18 pm #

    Please correct me if I’m wrong…

    Interest rates have little room to move down (and plenty of room to move up). Meanwhile, governments are issuing record levels of new debt. To make that debt more attractive, it seems to me they’ll have little choice but to push rates higher. Higher rates means lower bond prices. Hence, while you may get a little cash flow, your principal could take a serious beating. I think that bonds are a risky play with some corporate bonds being the exception.

    I’m not experienced enough in the coporate bond market to cherry pick the winners so I’m more inclined to focus on equities that would benefit from major trends like commodities (those needed by emerging markets and growing economies like China). I’m also migrating toward the dividend achievers & aristocrats so as to gain the benefits of (relatively) stable, increasing income streams with capital gains potential.

  13. Canadian Couch Potato September 20, 2010 at 2:42 pm #

    @Rob: You’re of course right about interest rates having little room to get lower. The problem is that no one knows when rates will rise or by how much, or how investors will react to other movements in the market. Everyone predicted long bonds would get hammered this year if rates went up. Well, short-term rates went up three times, bot long-term rates did not and iShares XLB is up 7% so far, and that doesn’t even include distributions.

    Dividend-paying stocks and emerging markets have a place in a diversified portfolio, too. But they are in no way “safe.” Both of these asset classes have lost 20% to 40% in previous market crashes and will do so again. During a crisis investors have a tendency to flock to government bonds, as they did in 2008 and earlier this year.

    My point is simply that no one ones what lies ahead, no matter how confident they sound. If you’re building a portfolio for the long term, it makes sense to diversify widely and forget about trying to pick the next “major trend.”

  14. Jasmin Levallois May 16, 2012 at 8:43 pm #

    Bernstein also recommends against a 100% equities portfolio except inside taxable accounts where high taxation rate of fixed income products can drag down the returns:

    http://www.moneysense.ca/2007/08/01/do-you-need-bonds/

    “Bernstein, a well-known author and money manager who has devoted much of his life to analyzing securities performance data, took me through the numbers and showed me that if you’re investing inside an RRSP, where you don’t have to worry about taxes until you take your money out, an all-stock portfolio just isn’t worth it. Part of the reason is that you’ll get an extra boost every time you rebalance a portfolio that contains bonds. For instance, if you have a portfolio that’s 60% stocks and 40% bonds, rebalancing it back to its original proportions once a year forces you to sell high and buy low, delivering an extra 0.3 to 0.5 of a percentage point per year. That helps elevate the performance of a mixed portfolio to the point where it’s getting pretty darn close to that of an all-stock portfolio.

    But here’s where the debate starts to heat up: Though your financial adviser would have kittens at the thought of it, Bernstein and others, such as Stephen Jarislowsky, the billionaire Canadian money manager, say that if you plan to hold a large sum of money outside of an RRSP for a long period of time, you may indeed want to ditch the bonds altogether and go 100% stocks. Why? Because the interest you get from bonds is taxed at a much higher rate than the capital gains and dividends you get from stocks, and those extra taxes drag down your returns. Bernstein’s opinion is that if you’re exposed to taxes, an all-stock portfolio boosts your performance enough to make the extra bump”

  15. Sue October 4, 2014 at 3:52 pm #

    Bond ETF’s vs actively managed bond funds vs bond index fund

    I am wondering if actively managed bond funds ever beat their respective indexes and therefore in order to save money on the high MER’s charged, is that why most investors would prefer to have a bond index fund or a bond etf?

    This is such a confusing area for me right now and perhaps for others as well. Reducing volatility and having regular fixed income I understand as being important to consider why its necessary to have bonds in your portfolio (RRSP I am referencing here) but with all the myriad of choices out there, how does one make the best decision.

    I am faced with this dilemma right now and my advisor is thinking actively managed bond funds are the way to go? but in looking into some of the offerings……they don’t even beat their index and what am I really paying for besides underperformance? I realize there are tracking errors associated with bond index funds (I’m thinking of TD) and ETF’s but on balance what is the best decision? and how freq. would one want to be adding to a bond ETF or re-balancing such that it does not make economic sense to buy EFT’s (i.e. lets say making a contribution 2x’s a year- there is likely opportunity costs with that approach to holding onto sums of money before you would put it in an ETF). And is now the right time to be buying a bond ETF?

    Any advice would be appreciated.

    Thanks,

    Sue

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