Is this crazy?
I don’t think so.
Typically, a good personal finance rule of thumb has been to have a percentage of your assets allocated to bonds, and this allocation percentage was generally tied to your age as a matter of simplicity.
So I’m 32 years old. This rule of thumb would dictate that I have 32% of my assets allocated to bonds and the other 68% allocated to stocks, and this allocation would change as I grew older (adding one percent to bonds every year I aged). This rule of thumb has changed over time, and there are variances to allow for other asset classes (gold, real estate, etc.), but this is the gist of it.
But one thing that people forget about personal finance is the “personal” aspect of it. And that’s where I like to come in.
I don’t think any allocation to bonds is necessary, and I would go so far as to say it would possibly be unintelligent to invest in them at all right now, depending on your personal situation. Obviously, we all have different individual scenarios, but I’m going to take a little time today to discuss why I personally do not have any bond investments, and why I don’t plan to change that anytime soon.
What Is Fixed Income?
First, let’s define what fixed income actually is.
Fixed income is basically a fixed source of income you receive from an investment. The income doesn’t rise with inflation, and is “fixed” or set at a particular rate or figure.
The most common sources of fixed income come from bonds. You can invest in bonds in a number of ways, including corporate (corporations) bonds, municipal (local municipalities), or treasuries (federal government). With a bond, you’re basically lending money to an entity in exchange for a fixed payment for a set period of time. At the end of that payment period you’ll get your principle (the amount you lent) back. Income from CDs are another form of fixed income.
One major reason I don’t invest in fixed income is due to the taxation regarding dividends and bonds, and how qualified dividends are taxed more efficiently for an investor than bonds.
I’ve discussed before the beneficial taxation that qualified dividends are subject to right now, and how that factored into my decision to invest solely in a taxable account, relinquishing the potential additional benefits of any tax-advantaged accounts.
Basically, with qualified dividends you’re looking at a 0% federal tax bill if you’re in the 15% ordinary income tax bracket or less. Ordinary dividends (typically REITs, BDCs, MLPs) , however, do not qualify for this preferential treatment.
But bond income is taxed as ordinary income. You’ll have to pay normal federal (and state, if applicable) income tax on any bond income you receive, except for certain tax-advantaged bonds like municipal bonds. So that means if you’re looking to retire early by building up passive income sources large enough to exceed expenses, you had better think carefully about how bond income might factor into that, and what type of accounts you invest in.
I personally plan on having a very low total tax obligation at the end of every year once I’m financially independent, because my total income will be relatively low and most of my passive income will be from qualified dividends, which are taxed at very preferential rates. As such, my path to financial independence is quite easy, as I invest most of my wealth in a taxable account that doesn’t require any of the additional paperwork and bureaucracy that tax-advantaged accounts typically require. Thus, I lose a lot of the headaches and gain most of the advantages.
Beta is a general measure of volatility, or systematic risk. A beta of 1 is on par with the general market. Any number lower than 1 would generally indicate a stock is less volatile than the broader market, while any number greater than 1 would generally indicate a stock is more volatile than the broader market.
You can commonly see a stock’s beta when pulling a quote.
Generally speaking, an allocation to bonds makes sense as the volatility in fixed income is lower than stocks. While the underlying value of a bond can fluctuate with interest rates, your income is fixed and your principle (assuming the entity doesn’t go bankrupt) will be returned to you at the end of the investment’s duration period. So by investing in bonds, you’re lowering the overall volatility of your portfolio.
However, stocks that pay and raise dividends typically have a much lower beta than the broader stock market, and therefore have lower volatility already built in. In my experience, my portfolio has been much less volatile than the S&P 500, and the value fluctuates from day to day much less. Thus, I haven’t felt a need for bond exposure to lower this volatility any more. In fact, I welcome volatility as it offers the opportunity to invest in stocks at potentially advantageous prices.
Take a look at The Coca-Cola Company (NYSE:KO). This stock sports a beta of 0.48, meaning it’s roughly half as volatile as the broader stock market. This beta bears itself out in times of fear.
From January 4, 2008 to December 26, 2008, one of the worst possible periods for equities, the S&P 500 declined by 40.18% (according to Google Finance). Meanwhile, KO declined by 28.42% during this same time period. Even better, the company continued to pay and raise its dividend throughout the massive economic recession because the company’s business model is solid, and people still need to drink beverages even if the economy sucks. They reported earnings per share of $1.29 at the end of 2007, and $1.25 at the end of 2008. I’ll gladly take a slight hit to EPS during one of the biggest recessions we’ve ever seen, especially when the dividends keep flowing and increasing like clockwork.
Clockwork, indeed. The annual dividend was $0.68 per share in 2007, $0.76 in 2008, and $0.82 in 2009. Like the Great Recession never even happened. It’s easy to calm one’s fears when more and more money is hitting the account.
I could repeat this exercise for any number of dividend growth stocks, but it generally works the same across the board. I notice when the S&P 500 is up significantly on the day my portfolio generally lags behind. However, when the S&P 500 is down significantly my portfolio doesn’t decline as much. For instance, as I type this article the S&P 500 is down -0.39% and my portfolio is down -0.12% for the day. Just a worthless anecdote, but I find that’s generally my experience. Of course, I don’t compare my portfolio to the S&P 500, so it’s just an interesting side note.
As I pointed out above, Coca-Cola’s dividends to shareholders kept on rising right through one of the biggest economic meltdowns we’ve ever seen. Meanwhile, any Coca-Cola bondholders saw no such advantage. Their payments continued, but at the same static rate they were enjoying before.
And that’s the big problem with fixed income: The income is fixed!
Are your expenses fixed? Is your monthly grocery bill the same as it was 10 years ago? What was gasoline priced at a decade ago? How about your property taxes – gone up in the last few years? Education? Healthcare?
Expenses aren’t fixed. Inflation is the secret tax that hits us all, no matter our personal situations. Inflation is quoted at somewhere around 2.1% right now, while inflation over the long run (since 1913) is somewhere around 3.2%. That doesn’t sound like much until you realize that prices will roughly double every 22 years.
Using this calculator, something that cost $20.00 in 2004 already costs $25.19 today. That’s a 25.9%cumulative rate of inflation over just 10 years. Extrapolating that out over multiple decades means you’re losing significant purchasing power if your investment income can’t keep up with inflation.
Meanwhile, going back to the Coca-Cola example the company has managed to increase dividends by an annual average of 9.8% over the last 10 years. That means your purchasing power is actually increasing, whereas an investor in fixed income is watching their purchasing power decrease over that same stretch.
If you were receiving $20/year in dividends from Coca-Cola back in 2004, you had 40 shares paying out $0.50 annually per share. In 2014 you’ll receive $48.80 in dividends from those same 40 shares, as the company now pays out $1.22 annually per share. So that $20/year expense that went up to $25.19/year is not only still covered, but you have extra change left over. That’s not the case, however, for someone investing in fixed income.
Ahh, Social Security. Will it be around when I’m older? Is it going to be destroyed?
I honestly don’t know, but I’d be willing to bet that it will still be around. As of December 31, 2013, 38 million retirees were receiving a $1,294 average monthly benefit. You don’t just take that away and replace it with an IOU. Pensions are increasingly disappearing, and Americans still don’t save enough (less than 5% of disposable personal income as of Q3 2013, according to NerdWallet) to build up sizable enough assets to produce the type of investment income one could live off of.
Per the SSA, among elderly Social Security beneficiaries, 52% of married couples and 74% of unmarried persons receive 50% or more of their income from Social Security. That’s pretty startling, if you ask me. That tells me that people rely on SS for a significant portion of their income, and that isn’t going to change. Therefore, SS will not disappear. It may change, and certainly I wouldn’t be surprised to see the age at which one can start to draw SS income rise as life expectancy increases.
Social Security is already like fixed income, except it’s even better because the payments are annually adjusted for inflation.. The volatility is obviously low, as SS is guaranteed by the government.
So once I’m much older and the rule of thumb indicates I should have a significant portion of my assets in fixed income, I’ll start drawing Social Security and that will be the icing on what’s already a pretty delicious cake! I don’t know what my benefit will be, as the SS calculator is difficult to accurately use because my recent move to self-employment involves a lot of questions regarding income, but even if it’s less than average at, say, $1,000 per month, that’s like a portfolio worth $342,857 invested at a 3.5% yield today.
Lastly, I don’t find a lot of value in bonds at all right now. The yield on a 10-year Treasury note is 2.62%. With inflation running above 2.1% right now, and the payments from a note set to stay static, I see almost no upside to that investment. Your investment is guaranteed to lose purchasing power over the next 10 years if you hold to maturity, while many high-quality stocks will offer a higher starting yield with growth in the income to boot. Why you’d jump at the opportunity for a lower yield with no growth makes little sense to me, other than the fact that your principle will be intact at the end of the ten years. Of course, that principle will be worth less in real value than it was when you started, so you’re effectively guaranteeing yourself that you will lose wealth.
And this isn’t to even address the potential for rising interest rates. I make no claims to my ability to forecast macroeconomic changes, and as such won’t do so here. But I would think the odds of interest rates staying this low forever are pretty low. Thus, your bond investment could potentially be exposed to a lot of volatility between the period of initial investment and maturity. If you’re holding to maturity, this won’t matter much. But if you’re looking for a way to lower your overall portfolio volatility, this might not be the panacea.
I’m not against investing in bonds completely. If rates were to rise significantly and the numbers made sense I might have a small allocation to long-term Treasuries. But I would never want a large portion of my wealth tied up in debt that pays a fixed amount of income when my expenses are held to no such check.
What About Buffett?
If you’re looking for guidance here, I’d like to take the time now to point out that Warren Buffett (Trades, Portfolio) himself is putting his faith almost exclusively in equities for his wife’s livelihood after he dies. Per the most recent annual letter to Berkshire Hathaway Inc. (NYSE:BRK.B) shareholders:
My money, I should add, is where my mouth is: What I advise here is essentially identical to certain instructions I’ve laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife’s benefit. (I have to use cash for individual bequests, because all of my Berkshire shares will be fully distributed to certain philanthropic organizations over the ten years following the closing of my estate.) My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.
If this strategy of low allocation to bonds works for Buffett, the most successful investor in history, and his will, it works for me. With this plan, he’s basically saying he better trusts the income equities can provide to his wife over bonds. That’s saying a lot.
Full Disclosure: Long KO.
What about you? What’s your allocation to fixed income?
Thanks for reading.