This may shock you. It is not something I like to talk about. It raises eyebrows and brings a tut-tut reaction out in many. I have next to no money invested in bonds. I'm retired and clinging to an equity centric investment strategy. I am skipping the investment step of subtracting my age from 110 to calculate the correct percentage of equities to own. (By that rule of thumb, I should have only 46 percent of my portfolio in stocks.)
Sometime back, as interest rates headed down, I watched the value of my bond funds climb. Bond funds, unlike bonds, do not mature. Bond funds act a lot like bonds that are bought or sold sometime during their investment life.
If interest rates climb and you are caught having to sell a bond before its maturity, you must sell your bond for less than its face value. This results in an apparent boost in the interest rate to spur interest in your bond. If interest rates drop, the reverse occurs. Your bond climbs in value. There is a formula used to calculate the exact change in value but the rule of thumb is:
A bond with a 10-year duration can be expected to change in price by approximately 10 percent when interest rates change by 1 percent. A fund with a 5-year duration might change in price by 5 percent when interest rates change by 1 percent.
For a more complete discussion of this and other bond related stuff, please read: Five Things Every Investor Should Know about Bond Funds. If you are about to buy into a bond mutual fund or a bond-based ETF, you should read Dan Hallett's piece "Distribution rate does not equal yield." Also read the comments. They are important.
When rates got as low as I thought they could go, I baled on my bond holdings. I sold all my XSB and bought stuff like bank stock, oil patch stock and stock based ETFs.
My wife and I have good stomachs for volatility. By thin I mean we can handle a loss without flinching. This is an important trait for an investor. Not everyone can accept a losing position with grace. On the other hand, everyone has a good stomach for gains. To tell the truth, when it comes to riding out the market's rough seas, I suffer financial seasickness well before wife.
Together we came through the crash of 2008-2009 intact. In fact, we bought more during the depths of that crash. Those purchases have proven to have been very good moves.
Which brings me to this question: Should a retired investor always be invested in bonds (or bond funds)? The usual answer is: yes. My answer, only applicable to me and my wife, is none or close to none at this time.
There is one caveat: My wife and I must be willing to ride out some big dips in the value of our portfolio and we must be aware that there is a small chance we could get trapped in our own, personal, financial Armageddon. But then, this is always a risk when investing in anything.
If interest rates were not at historic lows, I would not be touting the pure-equity portfolio. When rates recover, I will modify my approach. For now, I'm a pure meat eater, a financial carnivore. Pass the equities and hold the bonds, thank you.
Financial advisers tell me this is far too risky an approach to follow in retirement. I beg to disagree. There is no other sensible approach for folk like me. Period. Bonds do not pay enough. They are not an option. I am retired. I have only my pension from The London Free Press and my reduced CPP payments. I took a buyout at age 61and was forced to take a reduction of about 25 percent in both my pension and my CPP. My wife and I must make annual RSP withdrawals in order to live.
I don't want to cash any stock to raise money on which to live. I want to keep my portfolio intact, if I can. To that end, I only skim off the dividends. Buy low, hold and spend the dividends; That's my investment philosophy. If the share value climbs radically, dragging down the yield, I might sell and move my money to a dividend investment with a higher yield.
If I held bonds, I would not have the cash flow necessary to live. I would be forced to sell some of my investments. Bonds, GICs and the like are out of consideration. Interest rates are just too low.
What do others say about this approach? Amazingly, I can find lots of support for my no-bonds approach. For another take on asset allocation please read the linked piece on InvestorsFriend. This article presents data suggesting:
"A 100% allocation to equities has historically worked out very well, beating the balanced approach by a wide margin, by the end of almost all historical 30-year saving periods --- using data that begins in 1926. The only exceptions was for the recent for 30-year periods, the one started in 1979 and ended in 2008 where the balanced portfolio was the winner by 6% and the one started in 1980 and ended in 2009 where the balanced portfolio was the winner by a hair. However the 100% equity approach features some truly ugly volatility along the way. Also in the period 1981 - 2010, the 100% equity approach won only by a hair."
I hope you paid attention to the line where the author admits "the 100% equity approach features some truly ugly volatility." If you are going to go the no-bonds route, you've got to be prepared for the stomach churning twists and dips in the financial road.
I am mentally prepared for a drop in the market of up to 28 percent before I even break a sweat. I have built up a solid buffer over the past three years. My Excel retirement spreadsheet calculates what my present balance would be if I had realized an annual gain of seven percent while removing 5.8 percent to live. (My original goal was to remove no more than four percent but I have done so well that I am living high on the dividend hog for the time being.) In reality, I am enough ahead of that spreadsheet number to accept a 28 percent loss before my investment numbers return to earth.
With a 28 percent loss I would lose my buffer. The value of my actual holdings would be in sync with my spreadsheet calculation. In such an environment, my dividends might be cut a little but I don't see a big haircut. If, or should I say when, the market falls, I'm prepared to tread water for awhile while waiting for the rebound. I have some fat in my budget that can be cut in an emergency.
Here, I should confess that my original portfolio allocation included some bonds. I have deviated from my original allocation model for the reasons given earlier. When interest rates return to historic norms, I will buy some bonds. In such a financial environment, I will probably have some stock ETFs yielding less than XSB. It will the right time to get back a balanced portfolio.
In the interests of full disclosure, I must confess that I have some hidden bond exposure. If you look carefully at my holdings, you will find some bonds in my TD and the CIBC Monthly Income funds. Thanks to these two mutual funds, about 11 percent of my portfolio is in bonds. I also own some units of a Claymore preferred shares ETF. (In retrospect, the inclusion of CPD was a mistake.)
Let's give the last word to the U.S. Securities and Exchange Commission:
"When it comes to investing, risk and reward are inextricably entwined. You've probably heard the phrase "no pain, no gain" - those words come close to summing up the relationship between risk and reward. Don't let anyone tell you otherwise: All investments involve some degree of risk. If you intend to purchases securities - such as stocks, bonds, or mutual funds - it's important that you understand before you invest that you could lose some or all of your money."
Addendum: I found a calculator on the Globe and Mail site that compares the performance of a balanced portfolio to a pure stock portfolio during the biggest bear markets going all the way back to December 1968. I plugged in a balanced portfolio with a 60/40 stocks/bonds split. The balanced portfolio performed better more times but the stock portfolio had some amazing recoveries. In the end the stock market portfolio performed slightly better. Considering how much easier it would have been to sleep with the stock/bond mix, as soon as I can get some bonds back in my portfolio I will. The sooner the better.
I'm willing to give this one to the financial advisers.