In the past my index portfolio consisted of both stock and bond ETFs. I used to follow the age – 10 rule for the bond part. So at 25, I would have 15% of my portfolio in bonds and 85% in stocks. However, I decided to remove bonds from my portfolio entirely. You can read my complete investor’s policy statement here.
My investment strategy consists of buying low cost index funds and ETFs. Next to that, I’m looking to purchase real estate, ideally and apartment or duplex I can rent out. To save for a deposit on the rental unit, I invest only 50% of my savings every month in my ETF portfolio and keep the other half in a savings account. In this article I will explain my reasoning why I remove bonds from my portfolio.
Bonds and Bond ETFs
Investing in bonds means you are lending money to a government or corporation. A bond itself is given out by an organisation that wants to raise capital, and is purchased by investors. Holding the bond gives you the right to receive interest payments as well as receiving the full principal balance, usually at the end of the bond’s duration.
Because bonds are loans, they’re considered fixed income investments and therefore safer than stocks. You’re getting a fixed return, if you hold the bond to maturity. That return is the discounted cash flow for the interest payments that you receive every year and the principal payment at the end of the duration.
Before the bond matures, you can decide to sell it to other investors on the secondary market. The price of the bond is a result of supply and demand. But in general you can say that when interest rates are falling, bond prices go up. Vice versa, when rates are rising, bonds go down in value. Instead of holding individual bonds, you can purchase all kinds of bond funds and bond ETFs. Just like with stocks, this is the easiest way to diversify your investments.
The Case For Investing In Bonds
A reason to include bonds in your investment portfolio is lowering the volatility of that portfolio. Because bonds are fixed income securities, their value depends on the interest they pay and the general interest rates in the open market. Rates go op, bonds go down. But if you hold them to maturity, the bond will pay it’s principal balance in full unless the company goes bankrupt.
Stocks on the other hand, are expected to be way more volatile. They can swing up and down, depending on a lot of factors such as a company’s expected earnings, market sentiment and more. These days, stocks are increasingly volatile. Don’t be scared of that.
So even though bonds are not generating as much returns as stock, they serve a different purpose. They help protect your investments by being less volatile and guaranteeing a certain rate of return. Say your portfolio is 80/20 in stocks and bonds, which is very common. During a market crash, stocks might go down 40% in value. Bonds, sometimes seen as a safe haven, might go up say 5%. The investor that invested 20% of his portfolio in bonds is now down only 31%.
Another case for bonds is diversification. Diversification might be the only free lunch you get in finance and it works as follows. In the scenario above, where stocks crash and lose a lot of value, your asset allocation is not 80/20 anymore. It’s now 70/30. Since you decided on 80/20, you have to rebalance. When you do that, you sell bonds, that have gained value, and purchase stocks, that are cheap. So essentially rebalancing is a buy-low-sell-high strategy without timing the market. Like I said, the only free lunch…
Three Arguments To Remove Bonds
The reason I have sold all my bonds is that I have some compelling arguments on why, in my specific case, bonds are not the right investment for me right now.
The first argument is that I don’t really care about volatility. I’m 25, my investment horizon is practically until I die which might very well be another 60 or even 70 years from now. Volatility now will be but a blimp in the line over time. When stocks correct or crash, so be it. I’ll be ready and will continue to purchase. Will it hurt? Yes. Will I panic sell? Definitely not. Also, I feel safe for having an emergency fund ready.
The second argument is that for a young investor with a long investment horizon, I might argue that bonds are actually riskier than stocks, because they yield less on average. And the risk of returning less is a risk I don’t want to take at the moment.
The third argument is about rebalancing. As I’m removing bonds I will not have any of the rebalancing effects, right? Well, although that is true, I do hold a large portion of my portfolio in cash (to save for a real estate deposit). Since I want the balance to be 50/50, that cash will function as my rebalancing buffer. So for now, I can safely remove bonds from my portfolio.
Do you guys hold bonds? Or are you considering removing bonds from your investments?