Bonds

What are Some Pitfalls of Bonds Today, and When will they Subside?

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Quiz!

Which of the following statements are true? (There may be multiple answers.)

  1. Short-term bonds are attractive today, given their high interest payments.
  2. Short-term bonds are appealing whenever there is a large upcoming expense.
  3. Short-term bonds enjoy low volatility.
  4. Long-term bonds are attractive today, given their high interest payments.
  5. Long -term bonds are appealing whenever there is a large upcoming expense.
  6. Long-term bonds enjoy low volatility.

What are Some Pitfalls of Bonds Today, and When will they Subside?

Bonds offer much higher interest payments these days compared to 2 years ago. They are appealing for various uses. They are especially useful if you prefer/need to moderate the volatility of stocks. When deciding on a bond allocation, it is worth paying attention to the following pitfalls:

  1. Short-term bonds: After inflation and taxes, it is tough to get substantial income, and often the net real income is negative. For example, a bond paying 4%, to a person with 25% income tax rate, nets 3% income. With inflation of 4%, this leads to a -1% return. Tax-free municipal bonds address the tax penalty, but at a price of lower income, that also faces the inflation headwind. It is not a reason to avoid using them, but important to be aware of the issues when deciding on the allocation.
  1. Long-term bonds: Long-term bonds sometimes (not always) enjoy higher income but face an additional problem: the risk of rising interest rates. Historically, once inflation reached a 9% level, as happened last year, it took a median of 10 years to go back to normal.  So, without any bad luck, the bond becomes a risky investment for extended periods. The price of a 20-year bond paying 4% per year changes by 13% for every 1% change in interest rate. Compounding the declines for a 4% rate increase causes about a 40% decline. If you hold the bond to maturity you avoid the interest rate risk, but still have inflation risk. In addition, there are more compelling investments for long-term holding periods.

When would the risk of long-term bonds go down. Once Core PCE inflation (the measure that the Fed tracks) gets closer to 2%, the Fed may feel confident enough that it completed addressing the high inflation, and will more likely stop raising interest rates. While there are many factors affecting interest rate decisions, this is a prominent risk factor for bondholders.

Note that this article only pointed out a couple of risks of bonds today and is far from a comprehensive review of bonds. There are many types of bonds that are appropriate for different uses at different times.

Quiz Answer:

Which of the following statements are true? (There may be multiple answers.)

  1. Short-term bonds are attractive today, given their high interest payments.
  2. Short-term bonds are appealing whenever there is a large upcoming expense.
  3. Short-term bonds enjoy low volatility. [Correct Answer]
  4. Long-term bonds are attractive today, given their high interest payments.
  5. Long-term bonds are appealing whenever there is a large upcoming expense.
  6. Long-term bonds enjoy low volatility.

Explanations:

  1. While high interest payments are more appealing than low interest payments, you need interest payments materially above inflation to give appealing after-tax growth or income. Other investments can do this job better.
  2. Not knowing anything else, this statement is true: short-term bonds are appealing when there is a large upcoming expense. There is an important exception to this statement: when the total withdrawal rate (including the unusual expense) is low enough, it is possible to enjoy the benefit of stocks while supporting the unusual expense, as long as the investor is perfectly disciplined. Some large expenses can be broken down to a series of smaller expenses, alleviating the need for bonds. Examples are student loans and mortgages.
  3. Correct: Short-term bonds indeed enjoy low volatility.
  4. Long-term bonds seem attractive today, given their high interest payments, but they can decline in the face of rising interest rates.
  5. Long-term bonds are not appealing for large upcoming expenses. They can decline significantly in the face of rising interest rates, as seen in 2022.
  6. Long-term bonds fluctuate a lot more than short-term bonds with changes in interest rates. They have lower volatility than stocks, but not always low volatility.
Disclosures Including Backtested Performance Data

Why you should Hold Bonds in a Taxable Account

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Bonds are typically less tax efficient than stocks, leading to a common recommendation to hold bonds in retirement accounts and stocks in taxable accounts. This article challenges this advice for certain investors.

This article applies if you follow a plan devised by Quality Asset Management, or:

  1. You optimize your use of bonds: Income during stock declines and no other use.
  2. Your stock investments are highly diversified globally, with no market timing and no individual stock selection.
  3. Your stock investments have high average returns and a low turnover (i.e. limited annual sales of stocks; e.g. index mutual funds).

Bonds are less tax efficient than stocks

The notion that bonds are less tax efficient than stocks is the basis for the idea that bonds are a better investment to shelter from taxes, by putting them into retirement accounts. This notion is correct as seen in the table below:

  Bonds (mainly interest) Stocks (mainly capital gains)
Taxation frequency Done every year Mainly deferred to sale. Index funds hold each stock for a number of years on average.
Tax rate Ordinary income tax rate Mainly long-term capital gains

A deeper analysis can challenge the conclusion above.

Considering investment horizon

Given that you use your bonds whenever there are stock declines (assumption #1 at the top), as soon as you experience a stock decline, you would withdraw the money, and would not be able to put it back in. This would result in losing the retirement account tax benefit forever, due to a single stock decline.

There is a sophistication that can help you get around this limitation, but is not very practical due to its complexity and excessive trading.1

Comparing tax amount instead of tax rate

While the tax-rate of bond investments is higher than stocks investments, there is an offsetting factor. The average growth rate of stocks is much higher than bonds, magnifying the total tax amount , and offsetting the benefit of the low tax rate . A full analysis may become complex, given the combination of long-term gains and short-term gains, dividends and capital gains distributions. Instead, I will provide a simplified example to demonstrate the point:

  1. The tax on a bond fund with 5% interest at about 40% tax rate (federal 35% & state 10% minus a deduction of state taxes from federal taxes) is 2%.
  2. The tax on a stock fund with 15% growth taxed at 10% tax rate (federal 15% & state 10% minus 15% for the fact that taxation is mostly deferred) is 1.5%.

The faster growth of the stock investment keeps raising the tax amount. If we start with a $10,000 investment, here is the tax amount over a few years (under the assumptions above):

Tax on $10,000 investment in bonds vs. stocks Difference
Year Bonds (5% growth 2% tax) Stocks (15% growth 1.5% tax)
Principal Tax Principal Tax
1 $10,000 $200 $10,000 $150 -$50
2 $10,300 $206 $11,350 $170 -$36
3 $10,609 $212 $12,882 $193 -$19
4 $10,927 $219 $14,621 $219 $0
5 $11,255 $225 $16,595 $249 $24
6 $11,592 $232 $18,835 $283 $51

The faster growth of the stock investment resulted in a higher tax amount within 5 years, despite the lower tax rate.

While this example ignores some variables, and has simplified assumptions, it demonstrates the point that higher growth can result in higher taxes, even when the tax rate is lower and most of the taxation is deferred.

Summary

The rule of thumb: “hold bonds in retirement accounts, due to their worse tax treatment”, does not hold for investors that optimize their bond and stock investments, for two main reasons: (1) when withdrawing bonds from the retirement account during stock declines you lose the tax benefit forever; (2) the higher growth of stocks results in higher tax amounts over time.

1 Say you need $10k from bonds during a stock decline. You can do the following:

Taxable account: sell $10k stocks

Retirement account: sell $10k bonds, buy $10k stocks

Once your stock portfolio recovers, you can move the stocks in the retirement account back to bonds (sell $10k stocks, buy $10k bonds).

Disclosures Including Backtested Performance Data

How can you Maximize the Benefit of Bonds?

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Bonds are an excellent tool for limiting the negative impact of stock declines. This article will help you assess if you have a clear plan in place to make the most of your bonds.

It is common knowledge that bonds are a useful tool for retirees to help with current income given the high volatility of stocks. At the price of slower average growth, you get the peace of mind that your income will be there through the ups and downs of stocks. Let’s assess your use of bonds.

How did you use your bonds in the 2008 decline (choose the closest option)?

  1. As stocks declined, I increased my bond allocation, to increase my financial security, given the uncertainty in the world.
  2. I left my bonds as-is, and limited sales from stocks to amounts necessary for living expenses.
  3. I kept the percentage allocation to bonds fixed.
  4. I used bonds to cover my expenses, and did not make shifts between bonds and stocks.

How does each choice affect your financial security?

  1. As stocks declined, I increased my bond allocation, to increase my financial security, given the uncertainty in the world.

This is an intuitive option that many investors chose. It grows your short-term security in case the decline continues. There are two problems with this choice.

Every sale from stocks at a decline locks in the losses, and hurts your financial security for the rest of your life. Your long-term security is devastated.

A less apparent problem is: You gained no benefit from your bond allocation! The only reason to hold bonds is to avoid realizing losses in your stock portfolio. You did the opposite – not only did you not avoid selling stocks for current income; you accelerated the sales at the worst time.
  1. I left my bonds as-is, and limited sales from stocks to amounts necessary for living expenses.

This is a great improvement that avoids turning the temporary declines into a lifelong devastation. Most of the stock allocation is kept in place to enjoy the recovery.

It still has the problem of selling from stocks to cover living expenses instead of bonds. See the second paragraph in the frame in #1 above.

  1. I kept the percentage allocation to bonds fixed.

This is the disciplined approach according to common knowledge: keeping the allocation to stocks and bonds fixed at all times. It results in selling bonds and reinvesting in stocks after the stocks declined (“buy low”). If you followed this plan in 2008, you can be proud of yourself – you were probably one of the best investors out there.

  1. I used bonds to cover my expenses, and did not make shifts between bonds and stocks.

This approach maximizes the benefits of bonds. The reason to hold bonds is to avoid realizing stock losses. By making a full switch to bond withdrawals during stock declines, you completely avoid realizing stock losses. If you followed this plan in 2008, you are probably a rare investor who optimized the use of his/her bonds.

Conclusion

Whatever your intention for bonds is, make sure that your plan reflects it, and that you follow the plan during the worst declines. If you didn’t protect your interests perfectly, you need to come up with a more adequate plan, or a plan that you have the strength and discipline to follow.

#3 and #4 make good use of bonds, with some benefit to #4, given that it optimizes the use of bonds.

The main problem with a diversified stock portfolio is the risk of depleting it through withdrawals during steep declines. A bond allocation can help you avoid realizing large losses during stock declines. A plan that optimizes this benefit calls for withdrawing strictly from bonds, when and only when, your stock portfolio declines.

Disclosures Including Backtested Performance Data

When are Bonds Too Risky?

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In the previous article, ” When are Stocks Too Risky? ” (Hanoch, June 2005), you learned about the various risks of stocks and a way to use them without taking excessive risks. In this article you will learn about the various risks of bonds, and the ways bonds can be used without taking excessive risks. Let’s start by answering the question asked in the title:

When are bonds too risky? There are many risky ways to invest in bonds – many more than we would like to admit.

  1. Bonds as a long-term investment (including retirement) cannot effectively build your financial security. They provide low returns that result in minimal income after adjusting for inflation. The risk is not losing the dollar value of your investments, but outliving your retirement. When compared with carefully constructed stock investments described in the article mentioned above, bonds are too risky.
  2. Bonds cannot save us in case of an unprecedented global catastrophe . Historically bonds, as well as stocks, recovered from all declines and made up for the whole decline period. If you are losing sleep over the possibility of your stock investments being wiped out by a global catastrophe, you should know that bonds might not save you either. Most companies would be devastated and the government would lose its ability to tax people in order to repay its loans – bonds will lose their value.
  3. Any bond that is not backed by the government can lose significant value up to 100% in cases where the company that borrows your money fails and declares bankruptcy. This risk applies to all companies with no exception.
  4. Any bond not held to maturity can drop in value if interest rates go up, in order to make up for its lower return compared to new bonds.
  5. Any long-term bond has returns that are fixed for many years. If interest rates go up, the real returns of the bond go down. In certain cases, you might even lose purchasing power even if you hold your bonds to their maturity!

The first point above states that bonds cannot provide good long-term security. No matter what bond investment you choose, a carefully constructed stock portfolio (globally diversified, no stock selection or market timing and low costs) provides better long-term security that increases exponentially over the years.

What about short-term financial security? We know that stocks can be highly speculative in the short-term, making them useless for short-term security. Let’s find out whether bonds can be used to provide this security.

When are bonds safe enough? There is one case in which bonds can be safe enough: high-grade bonds, with a short maturity that are used solely to provide short-term security. All of these conditions must be true together, so I will detail each of them individually:

  1. High-grade (backed by the government with a limited amount of diversified corporate bonds)
  2. Short to intermediate maturity
  3. Only used for short-term security

These bonds tend to have limited fluctuations, making them ideal for short-term financial security. If you expect to use a large portion of your savings within the next few years, and there is no way you could delay the expense, you should not use stocks. A severe recession could leave you with a lot less in savings than you thought you had. When holding bonds, you are “paying for insurance” in the form of lower returns than company ownership (stocks), in order to know that the money will be there for you.

Are there alternatives to bonds that are better? There are many other alternatives to bonds for short-term security, including: checking, savings and money market accounts. All of these alternatives are either loans to the banks holding your money, or an aggregation of bonds and other short-term loans. They all offer lower returns with lower volatility, making them also viable for short-term security.

To summarize

Bonds are very important for maintaining short-term security. When using high-grade, short-term bonds you are likely to preserve your short-term security for the following reasons:

  1. Most of them are backed by the ability of the government to collect taxes, vastly decreasing the risk of default.
  2. Their short maturity makes them less affected by changes in interest rates.
  3. Their low returns are not a problem if their usage is limited to short-term needs, while leaving the long-term security to stocks.

No one guarantees that bonds will always provide perfect short-term security, but sticking to the ones mentioned above makes them likely to do so.

Disclosures Including Backtested Performance Data