A reader recently sent in this question on asset allocation:

I’m an investing newbie. Last year, I started investing in all four TD e-Series Mutual Funds in my TFSA on my own after reading your posts. I currently have a 30 percent allocation to bonds. Should I keep investing in TD Canadian Bond Index (e-Series) with interest rates forecasted to go up? Or should I cut down on the bond fund and allocate more into the other stock index funds?

Bonds have been terrific investments for a long time now. As of Sept. 30, 2013, Canadian bonds (as measured by the DEX Universe Bond Index) have returned 5.63 percent over 5 years and 5.22 percent over 10 years. Canadian stocks (as measured by the S&P/TSX 60 Index), on the other hand, had returned 3.72 percent and 8.45 percent respectively during the same time periods albeit at a much higher volatility including a significant stock market crash. Therefore, the natural inclination of many investors would have been to look at the recent past and concluded that they are better off in bonds than in stocks. Asking whether one should avoid an asset class after it has experienced a huge run up if therefore an insightful one.

Many smart asset allocators have publicly voiced the opinion that investors are likely going to experience poor returns in bonds. In an article in Fortune magazine last year, Warren Buffett has this to say about bonds: Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt: “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.”

Even if one agrees with the sentiment that expected returns from bonds will be poor, it still makes sense for an investor to hold some bonds. For one thing, the forecast of poor bond returns could turn out to be wrong. 10-year Government of Canada bonds are yielding 2.5 percent these days. 10-year bonds in Japan yield just 0.6 percent. If Canada were to, God forbid, experience a period of falling price levels, bonds will turn out to be better investments than stocks.

Bonds typically play a defensive role in a portfolio. Investors hold bonds to help them get them through the inevitable rough patches in their stock investments. When stocks fall sharply, bonds usually hold up their value because investors take flight to safety. Therefore, an investor’s overall portfolio does not experience as sharp a drop as their stock holdings. And if stocks fall far enough, investors can rebalance by selling some of their bonds and buying stocks at lower prices. This rationale for owning bonds holds up even if the prospective returns from bonds is poorer than usual.

This article has 17 comments

  1. I agree with you to the extent that investors should stick to their allocations. However, bonds are unlikely to benefit a portfolio. Their main value is to reduce volatility so that investors don’t panic and do anything foolish like sell off their whole portfolios. Gains from rebalancing help somewhat, but not enough to justify holding bonds for the rational investor who won’t need to access savings for more than 5 years.

    • Canadian Capitalist

      @Michael: I agree with your comment that the main value of bonds for long-term investors is lowering portfolio volatility. It’s an important role though because the risk is for many investors is that they will panic and sell in a downturn and swear off stocks altogether. Bonds help in reducing that risk and assuming an investor put together a sensible asset allocation, IMO, they should not deviate from it for tactical reasons.

      • I have to agree with not changing for tactical reasons. People have been calling for rates to rise for 2 or 3 years now and they still have not. If you made your changes 3 years ago well you missed out on some gains. I have to agree that we are in a special situation right now with rates having no where to go but up or stay level. In my past 40 years of investing, rates always had room to move up or go to some degree lower.

        My suggestion is to, either by addition of new funds or through rebalancing, to add shorter term maturities to bond holdings but not to sell my longer duration holdings or flip them to shorter term. Been slowly doing this the past few years. When interest rates begin to rise then I’ll think about whether to sell some of the longer duration bonds.

    • “but not enough to justify holding bonds for the rational investor who won’t need to access savings for more than 5 years.”

      Does that make all investors holding a bond allocation, and not planning withdrawals for over 5 years, irrational?

      Seems like a pretty wide brush that includes financial giants.

      Perhaps if dying with the most money was the ultimate goal one might make that argument. It rarely is.

      • @gsp: I was unclear. I tried in a later comment to explain what I meant (see below).

        Holding bonds does not give an expectation of higher returns for rational investors who have a long investing horizon. Irrational investors may get an expectation of higher returns by owning some bonds because they are less likely to sell out at a stock market bottom.

        People may choose to own bonds to limit portfolio volatility for a number of good reasons. I was trying to convey that seeking higher long-term returns shouldn’t be one of these reasons.

      • @MJ, agree about expecting lower long term returns. Still take issue somewhat with the quote below in your explanation:

        “The main value of bonds is to control portfolio volatility for investors who can’t handle such volatility for emotional reasons or rational reasons such as needing to use the money soon.”

        Once again, there are perfectly valid rational reasons for owning bonds that lead to greater certainty of comfortable outcomes. Dying the richest is very few investors’ ultimate goal and it seems to be the criteria you are using.

        Can’t help but find your depiction of irrational/emotional bond holders condescending. I say that as someone who doesn’t currently own a single bond or bond fund.

      • @gsp: I agree with you that many investors would find being called irrational condescending or even insulting. But I still think it’s true. I disagree with you when you say “there are perfectly valid rational reasons for owning bonds that lead to greater certainty of comfortable outcomes.” It can make sense to seek comfortable outcomes for the time when you’ll need your money. But needing comfortable outcomes for each month of returns on money that you won’t need for 20 years makes no sense to me.

      • @MJ, sorry for the delayed response, forgot all about this discussion.

        “It can make sense to seek comfortable outcomes for the time when you’ll need your money.”

        That’s all I was referring to. Agree that feeling good every day/week/month for a 20 year time span is not rational.

        What is so magic about 5 years? Should a rational investor 5 years and a day away from retirement not own any bonds but rebalance the next day? More importantly, why should someone who has no NEED to take additional risks do so at the cost of a lower certainty of a comfortable retirement? Explain why this person 5 years plus a day to 10 years from retirement should never own bonds.

        I continue to believe your criteria maximizes end of life assets rather than minimizing bad outcomes(not having “enough” when needed to meet one’s goals). It’s a silly(irrational ;)) goal for the vast majority of investors.

      • The only thing magical about 5 years is that it’s less than 10 years 🙂 You need to make a switch at some point, likely when you are scheduled to rebalance your portfolio anyways rather than on a fixed date.

        You mentioned a really important point, that people shouldn’t take needless risks. If your plan works with a portfolio that is 100% in bonds then that is a good move. Most people can’t do that because of a very low savings rate, and if they get a low rate of return as well they have a very high probability of ending up with very little. I don’t do that because my savings rate is high enough to withstand being wiped out completely multiple times (and I enjoy owning stocks).

        You’re not just maximizing your wealth when you die though. The only goal that is sensible for most people is to maximize their wealth at the point when they still start spending it, without losing their mind in the process. Expecting bonds to do this when they don’t anticipate spending it soon may turn out badly. You might wish that the safe route will also turn out best, but to expect it is irrational.

    • >>>>Gains from rebalancing help somewhat, but not enough to justify holding bonds for the rational investor

      Really? The info I’ve read disagrees with that. My understanding was that asset diversification and rebalancing reduces volatility and increases returns over the long term.

      • Probably one of us should point to some facts to back up our claims :). Michael’s claim makes sense, but stuff that makes sense doesn’t always reflect reality in the financial/investment field.

  2. @Michael: if one does not need to withdraw funds from one’s total portfolio for at least 5 years, then he does not need to hold any bonds (or fixed-income instruments) in his portfolio — is that what what you are saying in your comment? If yes, then is it because of expected low returns?

    • The comparison in this article shows that the 10-year return on bonds was 3% lower. That’s just a single data point but similar results apply in many other cases. If you paid no attention to the market for those 10 years, all you would see is that holding stocks had a better result.

    • @Be’en: After rereading my comment I realize that I was far from clear about my thinking. Let me try again.

      Some people (and I’m not accusing CC of this) seem to believe that the gains from rebalancing a portfolio of stocks and bonds can be large enough that such a portfolio is likely to beat an all-stock portfolio over the long term. This is not true. Bonds have to perform nearly as well as stocks for rebalancing to be able to make up the difference. We’ve had an unusually long run of good bond performance, but this is unusual.

      The main value of bonds is to control portfolio volatility for investors who can’t handle such volatility for emotional reasons or rational reasons such as needing to use the money soon.

      The worst strategy for most investors is to become tactical because they tend to make their tactical shifts at the wrong times or at best at random times.

      So, overall, I agree with CC’s post.

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  4. Dale@streetwise

    no one knows where yields will go. In the past they have remained low And rangebound for 15-20 years. The reason to hold bonds rarely changes. They could stay low, increase gradually, spike violently. Or fall.

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