An astute reader checked out my investment disclosure page and asked me a straightforward question: "Why do you own so many bonds?" That's an excellent question, particularly since interest rates are so low right now, making bonds a poor place to try to earn a strong return on your investment at the moment.
The answer boils down to a few variations on that old Will Rogers quote: "I am more concerned with the return of my money than the return on my money." For at least a portion of our portfolio, money that has a high likelihood of actually being there when we need it beats the potential for higher returns on that money. With that in mind, here are three reasons why we own bonds, and if any of them apply to you, they're reasons you should consider owning bonds, too.
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1. We will likely need the money in the not-too-distant future
Our oldest child is a freshman in high school, and he has three siblings not all that far behind him in age. Indeed, our next child is only a year behind him in school. As a result, in fewer than four years, we expect to start a twelve-year stretch of time where we constantly have at least one -- and often two -- children in college.
Although we live below our means, there is no way we can cover two simultaneous college tuitions on our take-home pay. While we hope our children will earn scholarships and expect them to work to help cover the costs of their educations, we also want to help them. Put all those factors together, and we expect to have to pull money out of our investments.
A smart asset-allocation guideline is that money you need to spend within the next five years does not belong in stocks. Since we have good reason to believe we will need to spend money from our investments within the next five years, that money belongs in something with higher certainty than stocks. Investment-grade bonds that are scheduled to mature around the time when we expect to need that cash fits that description, so that's where that portion of our money is.
2. We're on track for a comfortable retirement without that cash
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As long as the following assumptions hold true, my wife and I are on track for a financially comfortable retirement:
- We earn a decent (though not spectacular) rate of return on our investments over time
- Inflation remains under control for the foreseeable future
- At least one of us remains employed full-time until we reach a typical retirement age
- We face no major personal financial shocks, such as a long-term chronic disabling illness
Because that long-term future appears to be on track, we can shift a bit of our focus from funding retirement toward funding our family's other financial priorities, such as our kids' educations. Since those other goals are generally ones we'd like to address in the next few years, stocks aren't really an appropriate asset to own. Even in today's low-interest-rate environment, investment-grade bonds still pay better than a savings account at a local bank, which makes them worth considering instead of cash.
3. We need the buffer from some insane volatility
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A few years back, I started experimenting with options in an attempt to find Buffett's secret to 50% annualized investing returns. What I found was a strategy that appeared to work incredibly well until it didn't -- and when it failed, it failed miserably. In diagnosing what went wrong, I recognized that I had mistaken luck and volatility for skill. As a result, when my luck ran out and the volatility turned against me, I lost big from the magnified downside that comes with leverage.
Chastened by that experience, I decided that if I was going to continue investing with options, I would make it a point to find a way to cut down on overall volatility in that account. One approach I've taken on that front is to use the excess gains I get from those options when times are good to buy bonds in that account.
While that approach has taken me off the path of seeking Buffett's 50% returns, it has helped tamp down the extreme volatility that account had before. Wild swings are still possible, but they seem to be nowhere near as bad as they had been previously. For instance, on February 24, 2019, while the S&P 500 dropped by around 3.35 percent, that options-and-bonds account fell by 4.65 percent. That's "only" about 40% larger a drop than the overall market.
Believe it or not, that's an incredible improvement over how the account previously performed on bad days. When the account was options-only, it would often drop around four times as far as the market when things went sour. With the account less exposed to volatility than it had been previously, it's now a lot easier and feasible to manage through the market's downturns. That gives me a higher likelihood of sustaining the strategy than I had before, despite the lower returns now available when times are good.
Even in a low-interest-rate environment, bonds can make sense
As you can see, even in today's low-interest-rate environment, there are cases where it makes sense to own bonds. Whether it's to buffer against extreme volatility, cover some near-term expenses, or just because your plans are on track enough that you can cut back on risks and still wind up OK, bonds can play a role. Just don't expect those bonds to deliver a rate of return above their anticipated yield to call, and keep an eye out for default risks, and your bonds can still serve you well today.
