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A Reason to Own Bonds

Probably one of the biggest investment concerns today is the so-called “bond bubble.” Interest rates are at an all-time low thanks in part due to Central Bank bond buying and weak demand for borrowing in this slow growth economy. The fear of owning bonds has hit an unprecedented — and in my view,  unwarranted — level. There is a good reason to own bonds in a portfolio.

Everyone is bearish on bonds these days. Even PIMCO bond guru Bill Gross sent out a warning in a recent Investment Outlook newsletter, “the past decade has proved that houses were merely homes and not ATM machines. They were not ‘good as money.’ Likewise, the Fed’s modern day liquid wealth creations such as bonds and stocks may suffer a similar fate at a future bubbled price whether it be 1.50% for a 10-year Treasury or Dow 16,000.”

Advisors are quick to point out the protection bonds offer from a bear stock market. They say a fixed allocation to bonds will cushion the blow of falling equity prices. That happens sometimes, but not always. During the 1970s, higher inflation pushed bond prices down right along with stock prices. Both markets suffered together.

Warren Buffett doesn’t like the idea of having a fixed allocation to bonds either. During a CNBC financial news network interview, Buffett said “It's silly to have some ratio like 30%, 40%, 50% in bonds. They're terrible investments right now.”

If talk of a price bubble and diversification flaws doesn’t turn you against bonds, then maybe this will. You’re going to lose money on the safest bonds even if interest rates stay where they are. A 5-year Treasury bond is yielding about 0.8% today. However, the real interest rate is only -1.2%.  This is the return you get after inflation and before taxes on interest income.

Finding someone who likes bonds today is like finding someone who enjoys strolling through poison ivy. I don’t enjoy poison ivy either, nor do I like the low yield of bonds. Yet, I do believe there is a good reason for most people to own bonds.

Bonds, with all their problems, provide an important portfolio function. They give it protection against a certain type of risk — the worst type of risk — a risk than can permanently devastate a retirement account. A risk that is building every day as the stock market hits new highs. A risk that ultimately crushes many investors during steep stock market slides.

A bond allocation helps protect a portfolio from its owner.

Nothing causes investors to forget history faster than a bull market in stocks. As prices hit new highs and portfolio values exceed their high water marks, memories of bear markets melt like ice cubes on a hot summer day.

Investors become brave when the bulls are running and the bears have been trampled. How people felt during the past bear market is a distant memory. Some even start believing those four fatal words that eventually cause so much capital destruction in a portfolio: this time it’s different.

Perhaps it is different this time, but people aren’t different. If a person couldn’t stomach a high allocation to stocks during the October 2007 to March 2009 market meltdown, then they won’t be able to handle the next one. It’s not different this time.

Holding too much in stock and selling during a bear market is five times more costly than holding a lower allocation through a complete market cycle. It’s better to invest less and hold on than to invest more and panic sell. This is why bonds belong in portfolio.

Bill Gross may be right that bonds are in a bubble and Warren Buffett may be right that they’re a terrible short-term investment. I believe a bigger danger lurks for investors who follow short-term advice and shift their portfolios from bonds to a higher stock allocation.

Investing in bonds is a hedge against bad investment decisions. They may not earn a high return going forward and may even lose some in the next bear market, but I believe the psychology of holding bonds will stop some people from doing the wrong thing at the wrong time. A portfolio with a fixed bond allocation helps reduce behavioral risk and leads to a higher probability for long-term success.