I am going to start out by explaining exactly what a bond is for those who are not familiar with bonds and how they work. Bonds reflect money that a company or governmental entity borrows to finance some activity. The lender (investor) provides a lump sum of cash to the borrower and in return receives semi-annual interest payments for the term of the bond. The lump sum is returned to the investor when the bond expires. The rate of return is fixed assuming the investor holds the bond through maturity and is able to reinvest the interest payments at a similar interest rate. The interest rate will be determined by what the prevailing interest rate is for that type of debt at the time the bond is issued.
There is risk, however: if the company goes bankrupt its bondholders are not paid back their investment. Companies that are perceived to be more at risk must pay a higher interest rate to entice investors to lend to them. The bonds of these companies are called “High Yield” or “Junk Bonds.” The debt of the US Government (Treasury Bonds) is the least risky of all domestic bonds since the government can always increase taxes to provide funds to pay back their debt. Thus Treasury bonds generally pay the lowest interest rate.
So if Treasury bonds pay the lowest interest rate, then why do I recommend them to my clients instead of corporate bonds (or a Total Bond Market fund)? It is because the interest income derived from the bonds (“the return”) is not the primary reason bonds should be in a retirement portfolio in the first place. Instead, it is because bonds provide the best hedge against the volatility of the stock market.
What stocks represent is value of the projected accumulated income that will be left over after the bondholders are paid their interest. Thus the returns for stock holders can be much higher or much lower than the return for bondholders depending on how the company performs. The good news is that the track record for US corporations delivering superior returns for their stock holders has been strong. The historical return on stocks over the last 100 years has been 11% with inflation averaging 3% for a real return of 8%. For bonds, the return has averaged 5% for a real return of 2%. Going forward, projections for the next 30 years are for real returns on stocks to be in the 4-6% range and the real returns for bonds to be in the 0-2% range.
Unless you are very wealthy and your portfolio is already so large that it doesn’t really need to grow, you will need to invest in stocks to have any realistic chance that the value of your portfolio will grow fast enough to outpace inflation. You are simply not going to gain much by investing in solely in bonds for the return.
Of course, the stock market is not a smooth ride, as anyone who was invested in stocks in 2008 can attest. That year, the stock market was down close to 40%, which would rattle anyone. So how did bonds perform in 2008? Corporate bonds as a whole were down about 10% since corporate bonds are still perceived as somewhat risky. Treasury bonds, on the other hand, were up 15%. The reason for that is when there is great uncertainty you will see a flight to safety, which for the most part means a move toward US Treasuries. Treasuries are one of the only realistic “safe” options for the large money managers. It is not as if a hedge fund manager with a billion dollars can park that money in CDs at the local bank.
A portfolio that was invested 70% in stocks and 30% in Treasury bonds in 2008 would have been down about 25%, which is quite a bit less scary than 40%. A portfolio that was 35% stocks and 65% Treasury bonds (which is what I might recommend for a retiree) would have been down only about 8% in 2008 (which, by the way, was third worst year on record for the stock market and the worst in over 80 years).
So what adding Treasury bonds to your portfolio does is smooth out the returns on your stock investment to a point that you can comfortably ride out the market swings and stay invested to gain the superior returns that the stock market has always provided. I looked at each year going back to 1987, and there was not a single year when both the S&P 500 Stock Index and the Treasury Index were both down in the same year.
The issue for many of you reading this is that most 401k or 403b plans do not offer a Treasury Bond Index fund as an option. If you have some money in an IRA you can always shift your bond allocation there or make the best of what is available to you in your 401k/403b.
Feel free to reach out to me if you think you can use some help incorporating this concept into your portfolio.