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WE WANT OUR STOCKS to behave like bonds, and our bonds to behave like cash investments. That leads to all kinds of portfolio contortions—some of them damaging to our investment results.
Remember, risk is the price we pay to earn higher returns. Many folks want those higher returns, but they’re anxious to avoid risk. Chalk it up to loss aversion: We get far more pain from losses than pleasure from gains.
Result? Think about stock-market strategies like purchasing equity-indexed annuities and writing covered call options. Equity-indexed annuities capture part of the market’s upside while guaranteeing against losses—assuming the buyer owns the annuity for long enough. Meanwhile, writing call options allows folks to collect extra income in the form of option premiums, providing a small buffer against market declines, but the price is a cap on potential stock-market gains.
As investors look to limit losses, however, the biggest portfolio contortions tend to revolve around bonds, not stocks. The strategies employed typically involve favoring individual bonds over bond funds, and then holding those bonds to maturity. This can add a fair amount of complexity, especially if folks build elaborate bond ladders, with each rung designed to cover a particular year’s spending.
No doubt about it, there’s some reward for this complexity. If we buy an individual bond and hold it until it matures, we know exactly how much interest we’ll receive each year and how much we’ll get back upon maturity. Sound appealing? My advice: Before buying into the notion that bond funds are riskier than individual bonds, and that holding individual bonds to maturity eliminates risk, we should ask ourselves four questions:
To be sure, the risk of individual securities is reduced if we stick with Treasury bonds, which most experts believe carry scant risk of default. Worried about inflation? That can be addressed with inflation-indexed Treasurys and Series I savings bonds.
Still, I’ve never owned an individual bond, except a $75 EE savings bond I won for finishing second in a 5k road race. Why not? I’m not that concerned that my bond funds might be worth a few percent more or less than I’d hoped when it’s time to cash out. Why would I? Heck, I’ve lived through two 50%-plus stock market declines during my investing career, so modest fluctuations in bond prices hardly seem worth the worry.
Meanwhile, I simply don’t want the hassle and complexity of dealing with individual bonds, including Treasurys and savings bonds, and I sure don’t want to bequeath that sort of portfolio to my family. Given all the complaints I’ve read about dealing with TreasuryDirect, and especially cashing in Series I and EE savings bonds, I’m glad I made that choice.
But many readers, I know, strongly disagree.
Jonathan Clements is the founder and editor of HumbleDollar. Follow him on X @ClementsMoney and on Facebook, and check out his earlier posts.
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What kind of race gives out EE bonds as a prize? Talk about a sexy marketing ploy!
I too have never owned a bond, until one year ago when I put half my fixed income holdings into a 5-year TIPS at the auction via Vanguard.
That timing was smart (er, lucky); needless to say I’m pretty much a happy camper. Pretty much zero risk, absent TEOTWAWKI.
ETA: I’m of an age at which I now keep enough in fixed income to (along with SS) cover all expenses until The End. It’s a “Bonds are for me, equities for my survivors” strategy.
Having just looked at my portfolio YTD with the 1st Qtr in the books, I see that I have;
SPY (S&P 500 ETF) -5.19% (60% Portfolio)
BND (Intermediate Bond ETF) 1.79% (20% Portfolio)
VEU (international Equity ETF) 6.29% (15% Portfolio)
Cash 4% Annually (5% of Portfolio)
For the last couple of years, I have wondered if having everything in equities would make me better off. Given the current environment, I sleep better with some diversification that seems to work to help balance it all out. Not sure there are any perfect answers – just ones that I can sleep with at night.
I’d like to see more discussion of managing risk as opposed to minimizing or eliminating risk. As someone once said, the sluggard turns over in bed and says, “There are lions out there.”
I periodically look at the small part of my portfolio in bonds and I see how poorly they perform against my stocks, and I ask myself “Am I a sucker? Why do I put my money here to earn 4%, and that is before taxes and inflation?” Why should I even care about looking at alternative bond funds if all they do is vary by tenths (or even hundredths) of a point? But I still keep that small holdout of bonds in the same bond funds (even though I also have a decent pot of cash.) So, I ask readers – Am I a sucker in this day and age?
Do you follow the math or is this a more emotional question?
To me, bonds and cash are there to provide spending money if it’s a bad time to sell stocks. If you hold more than is necessary to cover five to seven years of spending needs, you’re likely doing it to reduce portfolio volatility. Holding more in bonds and cash than is needed for those two goals? Perhaps you have indeed allocated too much to bonds and cash.
I would add one thing here:
It’s better to own ETF’s for tax reasons than mutual funds. You’re not vulnerable to forced liquidations of fund holdings, that can trigger cap gains which are usually better done on your terms (not the markets)
Then on top of that, there’s the added expense of transactions in bond funds, both larger spreads and higher transaction costs, mean that forced redemptions can mean taking a permanent bite out of the total return.
Equities have similar concerns, but the nature of the equities markets mean the transaction costs (and ERs) are lower such that it’s not as big a concern.
A bond mutual fund could indeed be forced to sell securities by mass shareholder redemptions. But funds do at least benefit from institutional pricing — their transaction costs on secondary market trades are typically far smaller than those incurred by individuals.
Buying and holding individual Treasurys in a Vanguard account is not much harder than holding a bond fund like VGIT or VTIP. And for the past two years it has done so with higher yield and lower costs than the fund counterparts, each with billions of dollars of inertia in their portfolio. That’s true for nominal and inflation-indexed bonds, bought at auction or secondary market.
When yields rise sharply it takes years to buy that higher yield from a fund. If you’re living through the valley of Social Security deferral, that better yield is useful.
People who disagree in personal finance are often playing different games, and concerned about different time horizons.
When interest rates rise, bonds go down in price, whether they’re held in a fund or as individual securities. Focusing on a maturity value X years down the road doesn’t change what happens in the short-term.
I get the relationship between price and yield and mark bonds held to market regularly. In November 2023, I preferred a seven-year T-note yielding 4.875% for the next seven years to VGIT/VSIGX yielding ~3.3%. I knew the fund would eventually catch up.
Yes I do (strongly) disagree as I have said here before. I’m a little amused at the reference to the difficulty and complexity of buying individual bonds. Not hard. And if you are TIPS buyer there are now places to help you. I think there are pros and cons of TIPS but in our case I don’t find any of the 4 cons listed compelling in our case. We like a mix of our 8-10 rolling individual TIPS ladder as well as bond and stock ETFs. Works fine, not hard. Here’s a nice article from a well-known WSJ columnist who succeeded another well known and very well respected columnist. 🙂 How to Invest Your Money If the Election Has You Worrying About Inflation – WSJ
Ahh, yes. Minimizing risk versus the desire to eliminate risk. In my case, I don’t think risk can be eliminated. I do attempt to balance perceived risk with rewards. Bond funds are supposedly low risk but do carry some risk. A recent Morningstar article pointed out that the “5 Top-Performing Core Bond Funds” have had a 5-year annualized return ranging from -0.06 to +0.57%. That’s doesn’t keep up with inflation, which for my savings is my number one criterion. I exclude our monthly spending account. I have a goal that our savings outlast our lives. Inflation is a real issue that I must prepare for. Long-term (30-year) inflation has generally been in the range of 2.0 to 5.0%. I use 3.6% in my planner, but if it were to be sustained at 5% it could eradicate my savings by 2050. The return anticipated for our portfolio is realistic considering the allocations of stocks, bonds and cash. Real returns may be more, or less.
Individual bonds do have their downsides. I do consider bond quality and 89.26% of my bonds/funds and ETFs are rated medium quality or better. There are tools such as Morningstar which can aid in evaluating bonds including bond fund/ETF portfolios. In my view and most importantly, to get full value one must hold to maturity. T-Bills and other U.S. government issues are considered the most stable, but that didn’t translate into my TIPS fund/ETFs. One of them, a highly rated ETF is down 3.76% since 2020. That includes the value after reinvestment of dividends.
I haven’t had any issues dealing with Treasury Direct. Perhaps I’m lucky. When individual bonds mature I’ve elected to have the proceeds deposited into a bank account. Our bonds have been laddered and of shorter duration. I consider our I-Bonds to be set and forget. They will some day be redeemed. There are some government stipulations about this, so we’ll probably redeem before my death. My spouse can always repurchase after paying the tax.
CDs also have issues. Some banks which offer excellent rates only rollover at maturity unless advised within 30 days of maturity that the proceeds are to be cashed out and deposited at the bank of choice. Our calendars list these dates each year. That small inconvenience may be worth a few fractions of a percent. 0.5% yields $50 for each $10,000 per year. If that is considered negligible, it raises some questions. Why bother to look for better rates when one can settle nearly anywhere for 3.50% at present? I only state this because it really is a small amount, equivalent to $4.17 a month. Going for that extra 0.5%. Is that being frugal or cheap? Similarly, it is often stated that lower expense ratios for ETFs and other investments are better.
I really don’t understand the angst about Treasury Direct (TD) and cashing in electronic bonds. A few years ago, we set-up accounts and bought up I-bonds on TD when the rate was 9%’ish, for ourselves and our trust. We even bought ahead a couple of years using the personal gift bond feature for each other and then triggered a round of gifts each subsequent year at the $10K max limit/person. The most “difficult” aspect in all of this was properly categorizing our trust account on TD using the definitions on the site but we soon sorted it. Overall, the electronic bonds and online transactions were very straight forward.
The intent of this I-bond accumulation was to act as a large cash reserve for a significant cost emergency and/or pay off the mortage. As the interest rates have steadily fallen over the years, we opted to cash out some bonds to pay off the mortgage this year. Indeed, we forfeited the previous three months interest as all these bonds were < 5 years old. Not a crushing loss by any means at their current earning rates, especially in comparison to current stock market performance. The online process to cash out the bonds was very simple and the proceeds landed in our bank account within a few days. Happy to be rid of the debt but debt brings no other joy at its conclusion (our opinion). It’s still the same house.
I still have a handful of paper bonds inherited from my mother, that stop earning interest in mid- 2030. They are still pulling a bit over 5% so no hurry to cash them out early. I’m far more concerned about the paper process of mailing in the paper bonds to be reregistered in my personal TD account. Fortunately, for now, the bank down the street will still cash-in I-bonds and that’s my preferred method for these bonds when I’m ready.
When my dad died, my mom was frozen out of their joint TD account. They said 6 months to gain access. We’re at 7 now.
If I may, is it a trust account?
Converting paper bonds may take a year after TreasuryDirect has been DOGEd.
Yes indeed. Almost noted that in my response and am glad you did. Don’t know where this mess is headed but we’ll soon see, like it or not. Glad we don’t have to consider applying for SS in our days ahead – already there.
Everyone on this site knows you are very well informed and experienced, and have opted for simplicity of your own portfolio design. Your explanations here and in prior posts reveal why simplicity is not merely the default choice for those with limited knowledge or interest. While I would welcome a “risk- free” investment asset, there are none, just options with tradeoffs. Thanks for sharing your wisdom.
I inherited two different bonds after my Dad died. I took the bonds rather than have them split amongst my sister, brother, and myself – and gave them equivalent cash value to balance the transaction at the time.
The bonds really didn’t have a lot of value, and I didn’t want any individual issues, but as executor I thought I owed it to my sister and brother to simplify their portions of the estate. In both cases the bond issuer had the right to repurchase or buyback the bonds. There came a time when it was apparently worthwhile for both of them to do so (not at the same time). I remember being happy they were gone.
Well said and I agree. Just started reading again “How To Think About Money.” I like the part about noses pressed up against the glass in your introduction.
My favorite personal finance book.
Agree, bond funds suit us just fine. We will even probably liquidate our Series I holdings at some point just to further simplify the portfolio.
Thank you Jonathan for your common sense approach to bond funds and individual bonds. One year has made many decide that bond funds don’t have a place in a balanced portfolio. Recency bias is strong, but the alternative of individual bonds and CEFs has complicated many portfolios.
When I first started investing, I took a simple approach: stick all my retirement savings in stocks for long-term growth. There wasn’t much else to consider, since retirement was years into the future.
As I moved into my 50s, however, and straining to see my last work day on the horizon, I delved into the voluminous writing about portfolio-structuring for retirement income. Many involved complicated schemes of using various flavors of bonds. Contrast that with your suggestion for a simple approach using stocks and short-term government bonds funds.
It took me some time to shake the feeling that complexity was smarter, but wisdom is often disguised by simplicity. Jonathan, thanks again for continuing to hammer home the benefits of a simple approach to investing and living.