Why Own Bonds?

Bonds are boring, secure and predictable.  Interest rates are at historical lows because of this high level of safety.   The 30-Year Treasury Bond is currently yielding 2.75%.  With rates this low does it make sense to own a bond for three decades?

Interest rates are low, but they’re expected to rise in 2018.  Rising rates means more income for bond holders.  However, this could be trouble because when rates rise, bond prices fall.   A 1% rise in interest rates will lower the price of the 30-Year Treasury Bond by 17.8%.

Investing is a tradeoff between short and long-term goals.   Stocks and bonds can be used together to help you achieve your financial goals.  A diversified portfolio of stocks, bonds and cash is recommended.

Stocks have outperformed bonds because of the risk associated when investing in the stock market.  This is referred to as the equity premium and economist have pegged it at 5.5% over a 30-year period.[1]   If a risk-free bond is paying 2%, then stocks should return 7.5%.   

Three reasons to own bonds.

1.       If your time horizon is less than three years, owning high quality bonds is recommended.

2.       If you need to meet an obligation like a college tuition payment or the purchase of a new home.

3.       If you’re retired and need a secure income stream.

Three reasons to own stocks.   

1.       If your time horizon is longer than 20 years, buy stocks.  They’ve averaged a 10% return per year since 1926 and they’ve never lost money over a 20-year period.  

2.       If you’re contributing to your company retirement plan, allocate a large percentage to stocks.  Your money shouldn’t be touched for many years so take advantage of the long-term trend of the stock market. You’ll also purchase stock through a payroll deduction and this will help smooth out the short-term volatility of the stock market because you’re buying at different price points.

3.       If you want to create long-term wealth, stocks must be the focal point of your portfolio.

Let’s compare the performance of stocks to bonds with two Vanguard Funds – The S&P 500 Index Fund and The Total Bond Market Index Fund.   From 12/11/1986 to 11/30/2017, the S&P 500 Index Fund averaged an annual return of 9.74%.  A $100,000 investment 31 years ago is now worth $2.06 million.  A $100,000 investment in the Total Bond Market Index on the same day is worth $597,556 and it generated an average annual return of 5.94%.  The stock fund outperformed the bond fund by $1.46 million or 3.8% per year.[2]

A financial plan can assist you in deciding how much to allocate between stocks and bonds.  These two investments have different characteristics, and therefore they both belong in your portfolio.

Without good direction, people lose their way; the more wise counsel you follow, the better your chances. ~ Proverbs 11:14 (MSG)

Bill Parrott is the President and CEO of Parrott Wealth Management an independent, fee-only, fiduciary financial planning and investment management firm in Austin, TX.  For more information please visit www.parrottwealth.com.

December 11, 2017

Note:  Past performance is not a guarantee of future returns.  Your returns may differ than those posted in this blog.  Investments aren’t guaranteed and involve risk.

[1] https://www.investopedia.com/terms/e/equityriskpremium.asp, website accessed 12/11/17.

[2] Morningstar Office Hypothetical Tool, 12/11/1986 to 11/30/2017.