Why Bonds Suck
If you’ve been following this blog for a while now, you’ll have noticed that I don’t discuss bonds often, and when I do it’s clear that I have a very poor view on them.
So, I thought I’d clear up a few things about bonds, what they are good for, what they are not good for, why I don’t make use of them, and why most people probably shouldn’t be using them as long term investments.
What are bonds?
According to investopedia, a bond is:
A bond is a fixed-income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental).
A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments.
In a way, you could think of a bond as a way of renting money, where as long as you are renting it you pay interest (rent), and at the end of your contract, you return the money (principal).
There are many types of bonds, from corporate bonds, to municipal bonds, to treasury bonds, etc...
Most governments issue bonds as part of their course of business, as do most companies and local governments.
The exact parameters and values of the bonds change from issuer to issuer, and they also change over time in terms of interest rates.
The bond market is significantly bigger than the stock market in terms of tradeable assets, and even though the majority of bonds are owned and traded between institutions, many regular people do own and purchase bonds, particularly government issued bonds.
Bonds are generally seen as more stable and less risky investments than stocks, and so many people invest in them with the idea that it will make their portfolio less volatile and with fewer probability of loss.
Why I don’t like Bonds
The primary reason that I don’t like bonds is simple:
They have all the negatives of stocks, and none of the positives.
There, i said it.
This is something that many people, even well educated people familiar with the bond and stock market will push back against, but the fact is, they are wrong.
The reduced volatility part is one that many people will push back against because they are taught that “Bonds are less volatile than stocks”, but those teachings are plainly wrong, and those teachers should stop teaching it.
Bonds are not less volatile than stocks, and neither is real estate, or any other class of investment.
By and large, all investments are valued at the worth of the cashflows coming from those investments, discounted by a specific discount rate. That discount rate depends on a number of factors, including the riskyness of the investment, as well external factors that include alternative investment opportunities.
A rise in interest rates of US treasury bonds will impact the present value of already issued treasury bonds, just as much as it will impact the stock market.
Don’t believe me? Just have a look at what happened in the past couple of months:
What happened here was that the treasury bonds that were issued, are now being valued against other, more attractive alternatives, and therefore their values lowers to the extent where their attractiveness is the same.
These are essentially the exact same product, with the exact duration and risk profile, and with only a couple of months difference in the date in which the principal is to be repaid.
So when investors are looking to invest, they will simply pick the highest yielding one, and the lowest yielder will need to adjust its price downwards to make up the difference!
This is particularly visible in the case of bond ETFs, since they consist of baskets of bonds with different expirations, whose principal (and sometimes coupons) is reinvested back into the fund.
These ETFs just as volatile as any other index, and by buying into a continuously reinvesting ETF, with no set expiration date, you don’t even get the benefit of knowing that “At X date I will have my principal back”.
This exact same principal applies to any other investment, because all investments are alternatives to all other investments.
Now, volatility isn’t the only reason investors choose bonds, after all, “Lower Risk” is a label that is often (and unfairly) attached to bonds over stocks.
So you’ll probably argue:
Bonds may be as volatile as stocks, but they are less risky because they have priority in bankruptcy and in getting paid.
Now, this is true!
Bonds do have priority in bankruptcy, and bonds, unlike dividends, must be paid to bond holders, or the bond holders can force the company into bankruptcy to get their money.
Do I really need to tell you what wrong with this idea?
Should you really be investing in something where bankruptcy priority is a core component of your investment thesis?
Don’t get me wrong, if you’re a hedge fund, or a distressed bond fund with a lot of experience in the area, you can certainly invest in such types of things and make money on it.
But for the average retail investor, with little knowledge and little interest in chasing after bankrupt companies for years in the court system…
Does this investment make sense? NO!
The average investor should not be invested in something where bankruptcy is a core value proposition.
Such things shouldn’t even be in the picture because retail investors number one priority should be “Don’t put money in bankrupt companies”.
If a company you invested in, whether equity or fixed-income is in bankruptcy, you’ve already screwed up.
So in most cases, and particularly the cases where you as an investor want to invest in, bonds have no downside protection when compared to stocks.
They are just volatile, they still suffer from bankruptcy risk (even if the cost of bankruptcy has the possibility of being slightly lower). You have all the downsides!
Do you at least have any upside on it to compensate?
Not really, bond yields are currently at all time lows, and the yields of most well established companies often mirror the companies dividend yield.
And remember, dividends grow, coupon payments don’t!
As an equity investor, if the business does well without limit, you will be rewarded without limit.
As a fixed income investors, the business doing well is irrelevant (except to the extent it does not enter bankruptcy). You won’t get any extra coupon payments for it!
This might sound like a small thing, but particularly in rising inflation environments, bonds are problematic because your return is actually decreasing over time in real terms.
On the other hand, an environment with rising inflation tends to result in higher earnings (and dividends), so that even if that inflation related earnings increase is less than inflation… it’s still more than the zero you get from bonds!
The upside just isn’t there for bonds.