Why Should I Invest in Bonds? Part-1

Bond CertificateThese days, bonds are getting a bad name. Stock markets are off to a tremendous start in 2012, dividend stocks are outperforming, and not surprisingly investors are losing their confidence in government issued bonds. There are three main reasons why investors are spooked with bonds. First and foremost, are the sovereign debt woes in Europe and the antics of the U.S. government to raise the debt ceiling, which sent ripples around world markets last August. Second is the global and record low interest rate environment, with the potential threat of increasing rates. And third of course, is the low yield on government bonds versus the yield on dividend stocks.

The Shift to Dividends

As a result investors have lost confidence in their governments (bonds) and turned to corporations (stocks) for higher returns through dividends. For the first time in decades, investors were even avoiding German bonds – and Germany is one of the most economically stable countries in the world. Not surprisingly, many investors now have more confidence in the global conglomerates than they do in their own governments. But it never used to be that way. Government bonds were always viewed as more stable and a safe harbour in times of crisis.

The move to corporate bonds and especially dividend stocks has certainly been noticeable over the last few years. I’ve certainly been one of those investors riding that wave. Investors who have embraced dividend stocks have also been well rewarded, with increasing share prices and regular dividend income. In this era of low interest rates, the yields of dividend stocks have outpaced the yields on government bonds. But if you’re only looking at bonds from a yield perspective, then you’re missing the big picture. Let’s look back at 2008.

Looking in the Rear View Mirror

Driving and investing are much the same; you still need to keep moving forward. But you also need to look in the rear view mirror once in a while, to remind yourself where you’ve been. I’m reminded of recent times in 2007 to 2008 when stock markets were also doing well, and investors began selling their underperforming bonds to buy rising equities.

Many investors in 2008, even in their 50’s and 60’s, ended up with portfolios that had equity allocations above 80% or higher. Part of the reason was markets had been steadily rising for years (since 2003), so investors became blinded to the fact that markets move in both directions. Investors felt positive about stocks, but negative with underperforming bonds, and thereby increased their equity exposure. I covered this in a post nearly a year ago, Asset Allocation: Part-1 Risk Assessment. Yet no one could have possibly known the trouble that was looming ahead. Holding bonds through the financial crisis of 2008 and 2009 was exactly the right thing to do. It was also profitable.

Knowing what you know now, and you could turn the clock, would you have sold all your bonds and bought stocks in September 2008? 

Most investors would answer a definitive NO to a question like that. Yet at the beginning of 2012 we are also faced with a very similar investment climate to late 2008. Many investors are once again selling their bonds, buying rising equities (including dividend stocks), and throwing asset allocation out the window. So why are bonds and asset allocation so important?

There’s more to Bonds than Yield

One of the problems, is investors don’t realize that bonds and stocks are inversely correlated, and work together in a portfolio. That means when the prices of stocks decline, the prices of bonds usually increase, and vice versa. Comparing bonds to stocks, instead of understanding these are two different types of asset classes, is one mistake investors make.

Many investors also look at bonds solely in terms of yield. When you look at a bond’s YTM (Yield to Maturity) which is its worst case scenario, it’s not hard to understand why. Currently a 1-5 year Canadian Govt. bond ladder (Claymore CLF) is only offering a YTM of 1.3% (although the coupon distributions are much higher). With little potential for capital appreciation, dividend stocks certainly look a lot better. But throwing away your safety net (of bonds) while markets are on a tear (stocks) is a recipe for disaster. We only have to look back to the financial crisis of 2008 and 2009 to see the results of an all equity portfolio.

There’s a reason why successful and established investors diversify their portfolios between stocks and bonds – and big pension funds employ asset allocation as well. Bonds are not about high returns, they never have been. Bonds are about providing you a cushion, in times of market turmoil. And for that stability you also get a modest income in return.

Why You Still Need Bonds

I realize some investors choose 100% dividend stock portfolios, and these are my favourite blogs to read. But these guys and gals are not ordinary investors. They are fully aware of the associated risk and volatility they are taking, in return for the dividend income.

But for the average investor loading up all out on dividend stocks, is still loading up on equities. That’s fine if you’re a seasoned investor, and you have the stomach and discipline (as well as the cash) to buy on the dips. But if you’re new to investing a 100% equity portfolio could give you a big slap in the face. When markets turn sour, they turn quickly.

It’s easy to say “I can handle the volatility” or “I will buy and top up the dips”. But when your portfolio plummets 30% to 50%, where are you going to get the cash to top up? In times like these bonds not only give you a cushion and a soft landing, they also provide you with working capital to buy cheap stocks on sale. This is a point bestselling author Andrew Hallam makes so well (covered in Part-2).  Across my portfolio, bonds are my insurance against market volatility. This was readily apparent for me last August when markets tumbled quickly, and my stocks were down over 15% in couple of days, yet my overall portfolio remained intact. I wrote a few posts on the topic that month, including Keep Calm and Steady.

In Part-2, I’ll look at the threat of rising interest rates on bonds, why the returns on bond ETFs and Bond Funds are better than investors realize, and how to leverage the power of bonds in a declining market.

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34 Responses to “Why Should I Invest in Bonds? Part-1”

  1. youngandthrifty

    Jan 28. 2012

    Great post DN!

    I need to get me some more bonds- the only place I have them is in my RRSP and it isn’t proportionate with the rest of my portfolio.

    Thanks for the reminder :)

    Reply to this comment
  2. DIY Investor

    Jan 29. 2012

    Bonds have been a very good investment in recent years. In 2008,2009,2010,2011 the Barclay’s Aggregate Index (the bond market’s counterpart to the S&P 500 in the U.S.) returned 5.9%, 5.13%, 6.28% and 7.58% respectively. It has been a pretty good hedge against the stock portion of the portfolio.

    Reply to this comment
    • The Dividend Ninja

      Jan 29. 2012

      Robert returns on the Canadian equivalent, the DEX Universal Bond Index have also been quite similar, and I’ll cover that in Part-2. And long-term bonds as you know have also performed well – who would figure?

      When you consider decent yield, portfolio stability, and protection on the downside, they look good to me – esepcially here in Canada :)

      Cheers!

      Reply to this comment
  3. My University Money

    Jan 29. 2012

    I would argue now is definitely not the time to be in American Gov bonds. It’s pretty tough to defend current rates against equity gains going forward (especially when the Fed just announced they were going to hold rates until 2014). There might be some room for an investment grade bond-ETFs that give you a little higher income, but that’s all I can see in this environment.

    Reply to this comment
    • The Dividend Ninja

      Jan 29. 2012

      MUM I’m glad you posted, because I wrote this post for people who are only looking at yields with bonds, and comparing bonds to stocks. That’s why investors get into trouble, becuase they throw away their bonds and jump onto stocks. Yet bonds have performed very well over the last few years, and created portfolio stability, even with record low interest rates:

      “One of the problems, is investors don’t realize that bonds and stocks are inversely correlated, and work together in a portfolio. That means when the prices of stocks decline, the prices of bonds usually increase, and vice versa. Comparing bonds to stocks, instead of understanding these are two different types of asset classes, is one mistake investors make.”

      Cheers

      Reply to this comment
      • My University Money

        Jan 29. 2012

        I understand the concept of portfolio stability DN, but in my case, investing in bonds right now makes little sense. Due to my young age most advisors would recommend a small percentage anyway, but this is simply not a good entry point for the bond market. Your overall point of bonds vs stocks in terms or portfolio diversification makes a lot of sense, but that doesn’t mean that buying bonds tomorrow solely for diversification purposes is a smart overall move.

        Reply to this comment
        • The Dividend Ninja

          Jan 29. 2012

          MUM I totally get where you are coming from! and I also agree with you in part. The part I don’t agree with you on is trying to time the entry point. I’m just saying that becuase everyone has said bonds are a bad investment for the last 5 years – yet they have turned out to be great investments :)

          The part I do agree with you on is that it’s not the optimal time to buy either – you can’t ignore record low interest rates and the price of bonds (many now trade at premium). At some points rates will increase.

          That’s why I just keep bonds as a percentage and allocate accordingly. I just sleep better at night with that bond cushion (at my age LOL). But I can see that is not for everyone.

          Thanx for contributing. btw congratulations for starting your investing early!
          Cheers :)

          Reply to this comment
  4. Six Figure Investor

    Jan 29. 2012

    We’ve had a 30 year bull market in bonds. How much longer is it going to last? I don’t think we are ever going to see double digit long term treasury yields again, but I have to wonder when this bull market will end.

    Bonds can be just as dangerous as stocks, you can lose value. At this point I wouldn’t want to make bets on long dated bonds. You have pointed to a 1-5 year bond ladder as an investment. This makes good sense now.

    Reply to this comment
    • The Dividend Ninja

      Jan 29. 2012

      Six Figure Investor You are absolutely correct, when interest rates rise, bond prices will lose value. I definitely prefer to keep my bonds short (i.e. Claymore CLF),for this very reason. However the longer end of the yield can provide a higher return.

      People were saying the same thing in 2006 and 2007, yet we are still in exactly the same spot. In fact in 2008 people were really negative on bonds when stock markets were doing so well. So here we are in 2012 and what’s changed? Bonds are perfomring well, they provided stability, and they still seem to be great asset class to own. And this is in a low record interest rate environment. Go figure :)

      In Part-2 I cover this point exactly. Check out this article in the G&M by Dan Hallet (specifically the impact of rising rates):

      http://www.theglobeandmail.com/globe-investor/investment-ideas/experts-podium/how-rising-rates-may-affect-bond-portfolios/article2089692/page1/

      Reply to this comment
  5. Ken

    Jan 29. 2012

    Acknowledging the value of bonds within a portfolio, the question then becomes how to get access to them. For the moment, citing Hank Cunningham’s book, we will talk about individual bonds rather than access through EFTs.

    So, how does the DIY investor get access to the better bond desks? My advisor, who is generally quite good, claims that there is no actually individual access to the better bond issues. She claims that even those, like her, with access through larger investment arms, have often limited access.

    If that is so, then the idea of the individual investor taking good bond positions becomes largely moot.

    Reply to this comment
    • The Dividend Ninja

      Jan 29. 2012

      Ken thanx for posting! I’m not really too sure what your question is ;)

      Bond Index Funds and Bond Index ETFs are definitely the way to go – just in terms of diversification and cost alone of course (especially investors with smaller portfolios). Try replicating the DEX Universal Bond Index in ishares XBB – I doubt you could. There’s no reason for investors to buy bonds directly IMO.

      For example if you wanted to build a 1-5 year govt. bond ladder (as I used in the article as an example) you could do it with Claymore CLF for whatever amount you wanted. But if you bought 5 bonds directly, at 5K minimum, you would need 25K. And you would be unlikely to get a premium spread (commission) that a large investment firm like Claymore would.

      Your broker is right, it is more difficult to buy bonds directly and you really have to know the market. The bond market is nowhere near being as transparent as the stock market is.

      However at TD Waterhouse if I wanted to buy bonds directly, I could use the fixed-income section which has a large selction of securities, or ask the TD rep to buy the bond for me.

      Cheers

      Reply to this comment
      • Ken

        Jan 29. 2012

        My question came from the conviction of Hank Cunningham, in both his books and interviews, that individual bonds rather than EFTs are the way to go.

        That said, I do hold both CLF.A and CLG.

        Thanks.

        Reply to this comment
  6. spbrunner

    Jan 29. 2012

    I used to invest in bonds, although I must admit I invested directly, not through any fund or ETF. My experience was that they can be more volatile than stocks. The volatility depends on number of years to maturity and the longer it is the more volatile the bond value is.

    Although Bonds and Stocks do not move together, they do not necessarily move in the opposite direction either. I do not know what the correlation is, but they are not exactly inversely correlated. At least that has been my experience.

    I am still waiting for the very long bull market in bonds to be over and interest rates to rise and a bear market in bonds to being.

    Reply to this comment
    • The Dividend Ninja

      Jan 29. 2012

      Susan excellent comment. You do a bring up a really good couple of points (1) The longer the bond term the more volatile it can be, and (2) the correlation isn’t always exactly an opposite. I think you have a long wait for the next bond bull market ;)

      Cheers!

      Reply to this comment
  7. Vicky Vo

    Jan 29. 2012

    I have a couple questions for you, as I am definitely new to the whole bond world! You mentioned that you are invested in CLF (short term bonds); are they the only ones you have? I know longer term bonds are riskier at the moment due to our low interest rate environment, but do you diversify with some longer bond indexes? How about corporate bonds? What do you think about foreign bond content in a portfolio?

    Reply to this comment
    • The Dividend Ninja

      Jan 30. 2012

      Hi Vicky thanx for posting! I forgot to include my disclaimer on this post. I do have holdings in Claymore CLF and TD Canadian Bond Index e-series – and at the moment that’s it! ;) I do like ishares XBB and Claymore CBO (corporate 1-5 year ladder) and would like to add these. I do not have any funds or ETFs in foreign bonds, or plan to add any.

      Yes its good to have a diversified holdings of bonds, granted the longer bonds are more volatile (i.e. more sensitive to interest rate increases). That’s why I have a larger amount in Claymore CLF (short-term bonds – less than 5 years). But I am giving up some return for the shorter end.

      If you invest in a bond ETF such as XBB that follows the DEX Universe Bond Index, then you are already getting that diversification built in. It’s a mix of Canadian short and long term bonds, as well as government and corporate bonds.

      Here is a good post on Canadian bond ETFs:
      http://www.myownadvisor.ca/2011/09/11/my-favourite-canadian-bond-etfs/

      Cheers!

      Reply to this comment
  8. My Own Advisor

    Jan 29. 2012

    While loading up on dividend paying stocks over time, is fun, and I enjoy watching the dividends flow in, I do see myself in your post.

    I hold XBB and CLF in my RRSP, and I’m glad I do. I look back, in that rearview mirror and I still see the Great Recession in my sight. Some investors like Susan Brunner might not agree with me, but bonds provide me with a nice parachute when equity markets get messy and allow me to sleep comfortably.

    XBB in particular returned almost 10% last year, and just over 6% the year before. That’s pretty darn good from a bond :)

    I don’t hold any bonds beyond my RRSP account. I figure one account with close to 30% bonds is enough.

    I look forward to the sequel!

    Reply to this comment
  9. Dividend Monk

    Jan 31. 2012

    I think holding bonds is fairly important. It’s especially important for people who want lower volatility, lower overall risk, and a less “hands on” portfolio. But holding bonds is also useful as a “war chest” for times when there are lots of great buying opportunities, regardless of skill level or activity.

    I always hold some bonds, and the total amount of capital I keep in bonds, options, and cash depends on whether I’m able to find good values in the best dividend stocks or not.

    Reply to this comment
    • The Dividend Ninja

      Jan 31. 2012

      Dividend Monk thanx for the comment. ;) It’s refreshing to know even a big-time dividend investor such as yourself, also buys bonds and or cash for the reasons mentioned.

      Cheers!

      Reply to this comment
  10. 101 Centavos

    Feb 02. 2012

    Looking forward to part 2, DN. I have some bonds, but I’m careful to stay away from munis, at least for now.

    Reply to this comment

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