Stocks and stock index funds, as we saw in the previous chapter of “Index Investing for Dummies,” are the growth component of investment portfolios.
In chapter eight, author Russell Wild turned his attention to bonds and bond index funds, the stabilizers and downside protectors of investment portfolios.
If you had a $100,000 portfolio before the dot-com bust in 2000, how would bonds have made a difference? Wild laid out these scenarios for the 25 months between when the bust began, Aug. 31, 2000, and when in ended on Sept. 30, 2002:
- 100% in stocks: Ending value $55,880.
- 60% stocks, 40% bonds: Ending value $82,900.
- 40% stocks, 60% bonds: Ending value $96,410.
- 100% bonds: Ending value $123,430.
The author added, “Bonds are the best hedge going. And there's no better way to hold bonds, generally speaking, than in the form of a bond index fund.”
The figures above are based on gross results, i.e., fees not included. Fees are even more important in bond funds than in stock funds because returns are bound to be smaller. For example:
- If you pay a fee of 1.5% on a bond fund yielding 5%, you are surrendering 30% of your potential profit.
- If you pay 1.5% on a stock fund yielding 10%, that’s an automatic loss of 15%. That's not great, but still better than bond funds.
Bonds are simply debt securities, meaning you receive interest in exchange for lending an organization your money. Beyond that, the bond scene gets complicated, but here are some of the key components under the hood.
First, bond funds and index bond funds come in two main flavors: corporate and government. Drilling down, Wild told us that 64% of bonds are issued by corporations, while the remaining 36% come from governments, whether national or regional (as in municipal bonds, or “munis”).
At the time this book was published in 2009, 49% were issued in the U.S., 24% in Europe, 13% in Japan and the rest from all other countries.
Serious bond investors, though, will be more interested in a bond’s quality, which refers to its creditworthiness (how likely it is this issuer will be able to make its interest “coupon payments” and the principal payment at the end of term).
The better the credit risk, the lower the interest rate. To quantify creditworthiness, most bonds are given a rating between AAA and D. The colorful descriptions below come from Wild, while the sober—and sometimes sobering—ratings come from the major agencies:
In the U.S. and other countries, most types of bonds and bond funds are taxable:
- Those issued by the U.S. Treasury (including Treasury bills and Treasuries) are subject to federal income taxes, but exempt from state income taxes.
- Those issued by American municipalities are usually exempt from federal taxes (and sometimes from state taxes, especially if bought in an investor’s home state).
Investors also categorize funds by their maturity dates:
- Long-term bonds or long bonds have maturity dates at least 12 years in the future.
- Maturity dates between five and 12 years are considered intermediate bonds.
- Short-term bonds or short bonds mature within five years.
Because there are so many unknowns about the future, the longer the term, the greater the uncertainty. Thus, it is no surprise investors demand higher interest rates for long bonds. Both years to maturity and creditworthiness are major factors when issuers set yields or interest rates.
Turning specifically to bond index funds, Wild pointed out these funds do not have maturity dates like bonds, but most bond funds are made up of bonds within the context of long, intermediate and short terms. Very short bond funds are essentially the same as many money market funds.
Long bonds and bond index funds generate better returns, but they are not competitive with stock returns. Wild cited Morningstar (MORN, Financial) for the following findings:
- Between 1925 and 2007, the compound annual growth rate for long-term government bonds was 5.5%.
- Over the same period, long-term corporate bonds averaged 5.9%.
- When adjusted for inflation, the real rates were 2.4% for government bonds and 2.7% for corporate bonds.
- Again, over the same period, inflation-adjusted returns on stocks averaged 7.1% for large-cap stocks and 9.1% for small-cap stocks.
Note that these figures do not include taxes, so if interest payments were not tax sheltered, returns on bonds and bond funds could be near zero (this has held true since Wild’s book was published 10 years ago, with historically low interest rates since then).
So is there any compelling reason to buy bonds? Stability is one good reason. Another is downside protection, and there is also a steady stream of income (for what it’s worth after inflation and taxes). But Wild does have a couple of reasons and strategies.
The first involves rebalancing your portfolio regularly. In doing so, you sell the some of the stocks that are doing well and leave your other assets as they were. Next, you reinvest the cash that came in from rebalancing and use it to buy more bond fund units to help offset the erosion of inflation and taxes. The author calls this “juicing” a portfolio, adding it could improve performance by as much 0.50% per year.
Second, bond index funds offer diversification. Normally, there is little correlation between stocks and bonds, so when stocks take a dive, bond prices may go up. That’s not because of any change in the qualities of the underlying bonds, but because there is a “rush to safety” when stocks slide. Nervous investors typically pull money out of stocks and buy bonds or hold cash.
Third, during recessions or depressions, governments like to cut interest rates to get the economy moving again. Think of this as another form of “juicing,” one that can help investors who hold bonds and bond funds. When governments or central banks push down interest rates, older bonds paying higher interest rates will rise in value and investors get a bonus.
How should you choose bond index funds? The author explained, “I look for low costs, broad and solid indexes, and low costs (did I already mention low costs?).” In a securities’ universe with very low returns, every saving on the cost side will make a difference.
In this chapter, Wild made his case for including bond index funds in a portfolio. While bond funds will not contribute much to gains, they will provide stability in times of high volatility. Think of it as insurance that protects your portfolio, just as homeowners insurance protects your home.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
- Indexing for Dummies: Stock Index Funds
- Indexing for Dummies: Comparing Mutual Funds & ETFs
- Indexing for Dummies: ETFs and Alternative Indexes
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