Investors Love To Hate Bonds

I have plenty of conversations with lots of different folks from many varied backgrounds. When we get around to my bond trading past, where I received most of my hands-on risk management experience, the word "bonds" tends to generate two basic responses:

1) "I never really understood bonds"

2) "My advisor hates bonds and we have reduced our allocation"

If you are in camp 1, I highly recommend the three-part blog series that I did at the beginning of last month, starting with Do You Find Bonds A Bit Confusing? 

If you are in camp 2, I suggest that you have your advisor do the same, especially if they think that it is enough for your portfolio to just own a bond ETF (on which you pay an MER) as a substitute for the real item.

AAA government bonds are the safest asset that you can own. They are (despite their relatively light semi-annual interest payment) absolutely paramount for protecting your portfolio from the adverse impacts of stock market volatility.

However, as in the chart above, the cash flow yield of a very safe US government 2 year bond is now significantly better than the dividend yield of the S&P 500 (and way safer), so the reasons for not owning government bonds (i.e. cash flow) are being reduced. 

BBB or better ("investment grade") bonds will give you a little better yield and reasonable safety, but in more difficult economic times will have more potential for volatility (than government bonds).

Of course there is another option in the world of bonds where few advisors have any expertise (but we do) that can give you plenty of yield, diversification and are not in anyway subject to changing interest rates (i.e. zero correlation!). Another blog to assist you with understanding this: Stock and Bond Prices Falling Is Tough On A Traditional 60/40 Balanced Portfolio

All of these should be part of a broadly diverse allocation to bonds. 

More importantly, we need to be able to understand how important it is to be able to forecast shifts in the yield curve and how a strategy that maximizes the use of duration (average length of time to maturity) to allow us to continue to manage our important bond exposure (and limit the potential impact of rising interest rates that advisors fear so much).

Reducing bond allocations (unless you are increasing your cash weighting by the same amount) only increases your risk and exposure to potential volatility.

In my experience, people tend to hate what they don't understand. Well, we know and love bonds. We understand how important they are in a well-balanced and diversified portfolio. They just need to be managed properly. That's what we do. Solid, risk-adjusted, fiduciarily responsible portfolio management. It is way more than just Investment Advice.