An astute reader checked my investment disclosure page and asked me a simple question: “Why do you have so many bonds?” This is a great question, especially since interest rates are so low right now, which makes bonds a bad place to try to gain a high return on investment right now.
The answer comes down to a few variations on this old quote from Will Rogers: “I’m more concerned with the return of my money than with the return on my money.” For at least part of our portfolio, a high probability that your money is actually be there when you need it beats the potential for higher returns on this money. With that in mind, here are three reasons why we hold bonds, and if any of them apply to you, these are reasons why you should also consider owning bonds.
1. We will probably need money in the not too distant future
Our oldest child is a freshman in high school, and he has three siblings not far behind in age. In fact, our next child is only one year late for school. Therefore, in less than four years, we plan to start a twelve-year period where we will constantly have at least one – and often two – children in college.
Although we live below our means, it is impossible to cover two simultaneous tuition fees with our net salary. While we hope our children will win scholarships and expect them to work to help cover the cost of their education, we also want to help them. Put all of these factors together and we expect to have to withdraw money from our investments.
A smart asset allocation rule is that the money you have to spend over the next five years doesn’t belong to stocks. Since we have good reason to believe that we will have to spend our investment money over the next five years, that money belongs to something safer than stocks. The higher quality bonds that should mature when we expect to need this money fit this description, so that is where that part of our money is.
2. We are on the right track for a comfortable retirement without this money
As long as the following is true, my wife and I are on the right track for a financially comfortable retirement:
- We earn a decent (but not spectacular) rate of return on our investments over time
- Inflation remains under control for the foreseeable future
- At least one of us remains employed full time until we reach normal retirement age
- We are not facing any major personal financial shock, such as a chronic long-term disabling illness
Because this long-term future seems to be on the right track, we can shift some of our attention from funding retirement to funding other family financial priorities, such as educating our children. Since these other goals are generally the ones we would like to address over the next few years, stocks are not really an appropriate asset to own. Even in today’s low interest rate environment, high quality bonds still pay better than a savings account at a local bank, making them worth considering rather than cash.
3. We need the pad of some insane volatility
A few years ago, I started experimenting with options to try to find Buffett’s secret at 50% annualized investment returns. What I found was a strategy that seemed to work incredibly well until it didn’t work – and when it failed, it failed miserably. By diagnosing what had gone wrong, I recognized that I had confused luck and volatility with competence. As a result, when my luck ran out and volatility turned against me, I lost a lot of the amplified drop that accompanies leverage.
Driven by this experience, I decided that if I wanted to continue investing with options, I would make a point of finding a way to reduce the overall volatility of this account. One approach I have taken in this regard is to use the excess earnings I get from these options when the times are right to buy bonds on this account.
Although this approach moved me away from looking for Buffett’s 50% returns, it has helped reduce the extreme volatility of the account before. Wild swings are still possible, but they seem nowhere near as bad as they were before. For example, on February 24, 2019, as the S&P 500 fell approximately 3.35%, this options and bond account fell by 4.65%. That’s a drop of “only” about 40% more than the overall market.
Believe it or not, this is an incredible improvement over the previous bad day account performance. When the account was only options, it often fell four times when it comes to the market when things go wrong. As the account is less exposed to volatility than before, it is now much easier to manage during market downturns. This gives me a higher probability of maintaining the strategy than I had before, despite the lower returns available now when times are good.
Even in a low interest rate environment, bonds can make sense
As you can see, even in today’s environment of low interest rates, there are cases where it makes sense to own bonds. Whether it’s to cushion extreme volatility, to cover some short-term expenses, or simply because your plans are on track enough so that you can reduce risk while staying in order, bonds can play a role. Just don’t expect these bonds to outperform, and keep an eye out for default risks, and your bonds can still serve you today.