San Juan Mountains

San Juan Mountains
San Juan Mountains: Grenadier Range

Wednesday, November 30, 2016

Never Buy Bonds

For some reason that I have never been able to understand, investors continue to purchase bonds and bond mutual funds.  I understand the popular wisdom, which is almost always wrong, that as one ages it is important to shift a portfolio from stocks to bonds.  The general rule of thumb according to most of the folks I read is to maintain a percentage of bonds in my portfolio equal to my age.  So if I am 60 years of age my portfolio should contain 60% bonds and 40% stocks.  What a terrible idea that is.  I can't think of a better way to sacrifice total return in my retirement years than switching to bonds and bond funds.  Let me tell you why.
Basic economics tells us something very important about bonds.  Bonds come in two types:  government and corporate.  You should own neither of those types of bonds.  You should never own a corporate bond for the simple economic reason that equity must always outperform debt or the company issuing the debt will cease to exist.  Why would you own a corporate bond when you can own the company by purchasing its stock?  You know with absolute certainty that the stock, or equity, performance must be greater than the bond performance or the company will default on its debt and go out of business.  Buying a corporate bond guarantees you a lower rate of return than the stock of the company issuing the debt.  It makes no sense at all.
Government bonds are the dumbest things in the universe to buy.  Unlike profit seeking corporations, governments do not produce anything.  At least corporations can pay the interest on their bonds with real profits.  Government does not realize any real profits.  The only way a government bond can be paid off is by either taxing the people holding the bond or inflating the money supply of the people holding the bond.  In both cases the government bond holder is paying his own interest.  Whether it be via taxation or the thieving practices of inflation, government bond holders pay themselves the interest due on their bonds by one of those two processes.  If you would like to purchase a bond from me and then allow me to use the money and pay your interest either by stealing some of your money and giving it back to you (called taxation) or printing the money for your interest payments on a printing press in my basement (called inflation) I am very interested in selling you a Welsh bond. 
Long term returns on bonds are terrible.  Look at the graphic below.  The average rate of total return on bonds for the past 200 years is 5.2%. Compare that rate of total return to the rate of total return for the S&P 500 stock market index.  Over the last 100 years the stock market has returned 10.0%/year.  The stock market has also generated a 10%/year rate of total return since the year I was born.  Since the year I graduated high school and started my own investment portfolio the stock market has averaged 12%/year in total return.  Why would any person in his right mind invest in a vehicle that is essentially guaranteed to deliver lower long term rates of total return?  I am afraid I can't answer that question.  I truly do not know why anyone would ever purchase a bond fund.
There is one other thing you need to know if you plan on buying bonds, either individually or in a fund.  When interest rates rise the value of a bond falls.  Conversely, when interest rates fall the value of a bond rises.  Look at the graphic below.  Notice anything interesting about the rate of interest since 1981?  Right!  The bond market has been in a prolonged (35 year) bull market.  Interest rates are presently near zero.  Which direction do you think the rate of interest is going to go next?  And what will that do to the value of your bond fund?  Enough said.

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