The Arguments for an All Bond Portfolio in Tough Times
As a retiree of modest means in a tough market, you worry about how best to invest your money. If you really can't afford to risk any of your money to market downturns, then perhaps an all-bond approach is the way to go. By an all-bond approach, I mean pack your portfolio with highly rated bonds – i.e. Treasury and Treasury inflation-protected security type bonds, U.S. agency bonds and high-grade municipal bonds; but still keep 3 to 6 months of money in short term Treasuries or a money market for emergencies.
Forgo the usual equity portion of your portfolio and stay away from bond funds since they have a problems which we highlighted in our recent post on bond funds. Unlike bond funds which have a changing portfolio over time, you'll buy and hold your individual bonds to maturity. With this approach, you're looking for steady income for living expenses or building your portfolio and minimizing the chance of loss that bonds offer when held to maturity (note that no investment strategy can guarantee elimination of loss and individual bonds lack the diversification that can be achieved in a bond fund).
Granted, you're ignoring the research of Roger G. Ibbotson of Yale University in New Haven, Conn. His classic findings show that, historically, stocks have returned about 10% and bonds 5%. But this apparent advantage of higher equity return is undermined by several considerations:
- You must pay federal, state and sometimes local income taxes on equity gains (treasury securities are exempt from state tax and municipal securities are exempt from federal tax)
- Fees and expenses associated with fund holdings are not taken into account, and
- Your bad timing when buying and selling your equity funds or individual equities can seriously undermine your expected return.
So practically speaking, the historical return that individual investors received after these three considerations are accounted for brings the expected stock returns closer to the return of bonds. Note that if you had the stamina to hold stocks and not trade them at the wrong time (as most investors do) and your stocks were shielded from tax in a retirement account, the pendulum favoring stocks swings back in that direction.
Remember, if you buy newly issued bonds and hold to maturity, there is no capital gains tax, there are only minimum commissions that apply and there are no annual management fees. So after risk-adjusting stocks, bonds (when bought and held as recommended here) are clearly a less volatile and potentially more certain investment in tough times.
What about inflation?
Equities are commonly touted as the way to combat inflation, but stocks have taken enormous hits in the past during periods of severe inflation. Even under the high inflation of the 1970s, stocks crashed in 1973-1974. In 1973 stocks lost 14.6% and in 1974 stocks lost an additional 26.5%. Moreover, between 1966 and 1981 stocks essentially provided no positive return.
Clearly, you must hold equities through the long term to offset possible losses that the markets can produce (and you still have no guarantee of profit). As a retiree, you may be wary of having a long recovery time with limited resources.
For your all-bond portfolio, rising inflation means rising interest rates which you can take advantage of by creating a bond ladder. That way, you can reinvest the interest earned and principal that comes due each year in potentially higher-yielding bonds.
Financial advisors seeking to learn more about using bonds for clients can consult ProspectMatch