Why bonds?

I've been getting this question a lot lately: "why should I hold bonds in my portfolio?" And as is the case with any question that (a) is a good one, (b) I've been asked a lot, and (c) I'm likely to get asked again in the future (probably even decades from now!), it's worth talking about at length. Hence: this article!

The primary argument I hear is this: "Interest rates are low. The Fed has made it clear that they're likely to stay low. Given this, why should I hold bonds?" So...why?

Are bond returns expected to be low?

First, let's challenge the assumption that total bond returns are expected to be low in the near future. Answer: this...is actually a reasonable expectation. Current bond yields (the combination of interest rates and current bond prices) are a good predictor of future bond returns, and current bond yields are indeed low.

It's not a perfect predictor, of course, as there are other factors that come into play, but the returns on bonds are an order of magnitude more predictable than those of stocks. So if the expected-if-not-guaranteed returns are low, why invest in bonds? To answer that, we need to answer another question: what is our goal in constructing a portfolio?

What is our goal in investing?

The answer isn't necessarily as clear-cut as you might think. When you first start learning about investments, the answer might be something along the lines of "to make as much money as possible". If you think Shiny Investment A is going to make more money than Shiny Investment B, then invest in A. And that's what stockbrokers and Jim Cramer and all the rest are for, right? To tell you which shiny is better, and thus what to invest in?

Well...no, not really, and that's due to the nature of the stock market, and bonds and real estate and other investments, as well. The whole reason why you get a higher return for stocks than for, say, your savings account is because of uncertainty. Sure, that cool company that makes electric cars is great, and has a visionary founder, and is likely to do well in the future...but it might not. It might pull an Enron. Or some competitor might eclipse it. Or said founder might get hit by a bus. Or electric cars might get made illegal. Any one of a number of things could happen. Are they likely? Maybe, maybe not. But they could, so you don't know how the company will do.

So because there's a risk, investors insist on a potentially higher returns in order to be compensated for said risk. (Are you always compensated for risk? No, and there are plenty of examples of this. But conversely, it's extremely rare that you'll find an investment that's low-risk and high-reward.)

Point being: we have to factor risk into the equation. Therefore, our goal becomes "to make as much money as possible...without taking on too much risk." In the investing world, "risk" is defined as "volatility", and "too much" is of course a personal question, which I outline in terms of risk tolerance and risk capacity. (Side note: I'm pretty sure I've referenced that article more than any other in my entire blog.)

The point of bonds

If our goal is to create a portfolio that doesn't take on too much volatility -- whatever we've decided "too much" is -- then we need some way to "dial in" the amount of volatility our portfolio is expected to have. And this is where bonds shine: their volatility is much lower than that of stocks. The standard deviation of the S&P500 is around 15% plus or minus, which means that we expect the total return over any given year to vary by up to 15% up or down from the average about 68% of the time (and even more the rest of the time). That's quite a variation in returns! Meanwhile, the standard deviation of the Barclays US Aggregate Bond Index? Around 4%. Not nothing, but a great deal less.

Another way to think about it is this: how long would it take for you to recover from a large downturn, and how much would you have lost in the meantime? According to my analysis software Kwanti, the largest downturn over the past 25 years for the S&P500 was 56.8% during the Great Recession; it took 517 days to go from the top to the bottom, and it took another 1,480 days for it to get back to where it was. That's 5.4 years total. Meanwhile, the aforementioned bond index's largest drawdown was in March of 2020, when it lost a whopping...6.3%, and it took 103 days to get back to where it was before the pandemic shook things up.

Moreover, not only are bonds stable, but their returns are generally uncorrelated with that of stocks; the correlation coefficient between the S&P500 and the Barclays US Aggregate Bond Index is near 0 (1.0 means they move perfectly in sync, -1.0 means they move exactly in the opposite direction). This means that chances are decent that if the stock market takes a dip, bonds won't do so.

So all of this means that bonds are ideally suited to be a "stabilizer" for your portfolio, the primary ingredient that you add more of as you want less volatility.

Cash, efficiency, and the Sharpe ratio

You may be thinking, "sure, bonds are sort of stable...but they have had downturns. Cash has even less volatility; if I want a stabilizer, why not use that?" (I define "cash" broadly: checking, savings, money market funds, etc. -- anything liquid that is 99.9% likely not to go down in total value.) The answer hinges on whether they create a more efficient portfolio than bonds -- and when I say "efficient", I mean "efficient in terms of risk v. reward".

Remember that the object of the game is to get as much return as possible without taking on too much risk. This means that, overall, you want assets that increase your portfolio's returns as much as possible while increasing the volatility as little as possible; alternately, since we're going in the opposite direction for this example, you want to decrease the volatility as much as possible while decreasing the returns as little as possible. So in order to have a decent measuring stick, it would be good to have a measurement of a given portfolio's return as a function of its volatility.

Enter the Sharpe ratio, which is actually fairly straightforward: it's the average return earned in excess of the "risk-free" return (we generally use yield of 90-day Treasury bills) per unit of volatility. Voila! A measurement of risk-for-reward efficiency.

(Now, to be clear: any given investment's Sharpe ratio is good to know, but an incomplete picture, because what we actually care about is the effect on the portfolio's Sharpe ratio when the asset is added to it. While an investment's Sharpe ratio is a good starting point, remember that correlation with other assets in the portfolio will also have an effect on overall volatility, and thus on the Sharpe ratio.)

So on the surface, the problem is relatively simple: if I create a portfolio that has a higher Sharpe ratio, that means that I can achieve the same returns with less volatility (or the same volatility with higher returns, if you prefer). And investment managers often use portfolio analysis tools for this very purpose. But bear in mind: the calculated Sharpe ratio is based entirely on historical data, and this form of "backtesting", while useful, is by no means perfect, and can sometimes be downright misleading! And the higher the volatility of the portfolio, the more noise is in the data, and thus the more imperfect this measurement is.

(Yes, this is a complex topic; you can check out more in this article on measuring portfolio performance.)

But with bonds and cash, because of the relatively low volatility, the data tends to be more reliable, and it generally indicates that cash is less efficient than (high-quality) bonds. Why is that? The answer is tied to the question of why you would want to use cash, and the answer is: when you absolutely, positively do not want to lose money in the short term. Sure, it's less efficient in the long term, but because it is extremely reliable in the short-term, even more so than bonds, this is okay (and this is why investors are willing to accept lower returns, and thus the lower efficiency).

This is why I most often recommend to clients that they save for short-term goals using cash, and keep only a minimal amount of cash in their (long-term) investment portfolios.

So...what's the answer?

To sum up and oversimplify just a bit, the answer to the question of "why should I hold bonds?" is "because they're a highly efficient way to reduce the volatility of your portfolio". Just because the returns are lower doesn't necessarily mean that there's something out there that is more efficient; anything that has higher expected returns is almost certainly going to have a higher volatility. If you're not OK with that, then you likely need to stick with bonds. And if you are OK with that, then why weren't you targeting a higher volatility -- and thus higher returns -- in the first place?

It's all about risk tolerance and risk capacity, and why yes, I am going to keep banging the table on that point. If you can get that part right, you're already halfway there!

(PS: note that nowhere in this conversation have I talked about "portfolio income". There's a reason for that.)

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.