Why bonds are poor investments
And why the sell-side can't stop themselves from promoting fixed income
Bonds are nothing more than a contract between an investor and an issuer (often through the form of a trust indenture). Investors can only receive the benefits they contracted for, or less in the case of an issuer failure, unless the contract includes some optionality - like a conversion feature or attached warrants to buy the issuer’s stock. But the vast majority of bonds have no such features.
The U.S. bond market is enormous, comprising about $50 trillion of debt, more or less equal to 40% of the global bond market. Money managers can earn billions of fees for managing bond portfolios and assisting clients to trade bonds. As a result, they peddle the theory that bond investors benefit from a drop in interest rates that propels the trading price of bonds upwards. They want their clients to trade since that is where they make money, or to pay a management fee to have an “expert” manage their fixed income holdings. But every gain for one investors is matched by a loss by another, since the bonds won’t create any new value beyond the contracted terms.
It is a scam.
The iShares Core U.S. Aggregate Bond ETF (AGG) is a good proxy for the bond market, and as of last week had an average yield of 4.9%. If you invest in bonds, you get 4.9% on average, depreciated by inflation every year. With current inflation rates in the 3% range, your real rate of return this year is about 2% before fees and expenses.
How much are those fees and expenses? They range from 0.40% to 1.5% more or less. SPDR Bloomberg High Yield Bond ETF (JNK) has a gross expense ratio of 0.40%. BMO High Yield US Corporate Bond Index ETF (ZJK) has a management expense ratio of 0.61%. Passively managed ETF bond offerings have MER’s as low as 0.10%. So bond investors as a group get returns of less than 2% on average in real terms.
That is in the short term. Inflation doesn’t go away and persists because the Fed and other central banks plan for it to persist, setting targets for inflation (currently 2%). For a 30-year bond with a coupon today of less than 5%, the value of the principal repayment 30 years from now will be 45% less than its face value and real purchasing power when issued if average inflation over the period averaged 2%. But it is more often than not well over 2%.
If you buy bonds, especially long term bonds, you are lucky if you get a return of your money rather than a return on your money. Brokers and portfolio managers push bonds as an element of a “prudent portfolio” and the age-old 60:40 rule pretended investors were better off with between 40% and 60% of their portfolio’s invested in fixed income instruments. Your pension fund almost surely has such a rule.
The justification for the 60:40 rule is to avoid volatility - measured as changes in the value of holdings as it changes on a daily basis but annualized using a normal distribution. After all, clients don’t like to hear the trading value of their holdings went down and portfolio managers don’t want to lose clients.
Some things are obvious. If you invest with a short term horizon since you need the return of your money in the near term (say within a few years) a 60:40 portfolio or its equivalent will protect you from exposure to market downturns that may be ill-timed in relation to your investment horizon. But if you want to accumulate wealth for retirement or to build an estate to leave for your children, and do not foresee any need to realize on your investments for decades to come, a 100% equity portfolio will produce far greater returns than one that follows the 60:40 rule or its ilk.
You can safely ignore metrics like the “Sharpe ratio” that compare your risk-adjusted return to a market average return since you should care less about “risk-adjusted” returns and care solely about the long term appreciation of your investments in real rather than nominal amounts.
Do 60:40 portfolios help reduce risk and, in terms of the cost of that peace of mine, how much difference does it make? Take a portfolio of $10 million and compare:
The base portfolio: $4 million invested in 30-year treasuries and $6 million in the S&P 500.
The alternative portfolio: $10 million invested in the S&P 500.
The base portfolio would have an ending value of about $98 million after 30 years if there were no withdrawals. I am assuming a tax free pension account for comparison.
$4 million principal repayment of the bonds
$9.9 million interest on the bonds at 4.9% for 30 years
$80 million comprising the equity portion at an average return of 9%
$3.1 million interest on the reinvestment of the bond interest received each year.
The second would have an ending value of about $133 million (10x1.09^30).
Is the insurance against a potential loss of reported “value” in a given year or two worth giving up $35 million of value? Seems unlikely, unless you live in fear.
In a 2023 paper entitled “Beyond the Status Quo: A Critical Assessment of Lifecycle Investment Advice” the authors argued that long term funds like pension funds should be 100 % equity and the cost of social services or Canada Pension Plan would be trillions less than under the current paradigm. Not surprisingly, the paper came under immediate attack from the sell-side and money-management community. The virulence of the attack reflects the threat of common sense to the established order on which they earn their living.
Is is indisputable that, notwithstanding year to year volatility, long term returns from investing in profitable corporations like the S&P industrials will produce better outcomes than paying young MBA’s and CFA’s a fee for telling you otherwise and managing your retirement fund for their retirement, not yours.
Give it some thought when you put your money at risk and ask yourself - am I really a trader, a short term investor or a long term investor seeking to accumulate wealth. It matters.