Bonds
Stock investing is risky business.
So, what can you do to protect yourself?
At the start of the Iraq war in 2003, Dick Cheney had about 25% of his impressive hundred million dollar portfolio in international bonds, including many French Government Bonds. Keep your eye on Dick. Another thing you can do is prepare for the worst. I would say the worst is a Weimar Republic type of meltdown. I don't believe it's gonna happen, but we're gonna have to be careful not to tempt fate with too much more "patriotism". If it does happen, then there's not too much you'll be able to do to protect yourself this time around, so don't spend too much time worrying about it.
Regardless, what are the implications for US investors? If we can avoid a global economic meltdown, and if we can avoid a global nuclear holocaust, then I would guess (and that's all anyone can do) that the prospects for US investors are as good for the future as they have been for the last fifty years. That means that you can expect declines of 50% or more in the US and global stock markets in the future AND you can reasonably expect advances of 50% or more. If we are all lucky, the advances will be greater than the declines. Stock investing is risky business and all of us are well aware of that fact right now.
I wrote that Dick Cheney put about 25% of his impressive hundred million dollar portfolio into international bonds, including many French Government Bonds. How good a move was this? The answer is that it depends on when the bonds were purchased. International bonds are currently primarily Euro denominated bonds. At the end of 2001 a US dollar would have purchased 1.12 Euros. At the end of 2007 a US dollar would have purchased 0.68 Euros. That means the US Dollar lost close to 40% of its value during that period. It also means that international bonds were an incredibly good investment.
Should international bonds be in your portfolio?
Here are some return data:
All returns are TOTAL RETURNS for the FIVE YEAR period ending June 30, 2006
Vanguard Intermediate Term US Bond Fund (ticker VBIIX) 26.8%
T. Rowe Price International Bond Fund (ticker RPIBX) 57.3%
How risky are international bonds?
The Vanguard Intermediate Term Bond Fund (ticker VBIIX) returned 83.7% over the TEN-YEARS ending June 30, 2006. The T. Rowe Price International Bond Fund (ticker RPIBX) returned 57.6% over the same ten-year period, meaning it returned almost nothing for the five-year period ending June 30, 2001
Most folks buy bonds for income AND they buy them to reduce the risk of a portfolio. I have rejected international bonds for my personal portfolio because they generally do NOT provide income equivalent to US bonds, they are considerably more risky than US bonds, and the expenses are considerably higher than a Vanguard bond fund.
Should you buy individual bonds, or should you buy a bond fund?
I have done considerable work in this area and I cannot think of a good reason to buy individual bonds instead of a well-managed bond fund with ultra low expenses. If you know of a good reason to buy individual bonds, then please share it with me. Individual bonds present a host of challenges for the do-it-yourself investor. First of all, buying individual bonds can be expensive. With very few exceptions, bonds are not listed on an exchange. To trade, you must get quotes and execute orders through a broker.
The initial investment in a bond fund, on the other hand, is typically much smaller than purchasing an individual issue, but with that lower price of admission actually comes greater diversity. A bond fund, which typically holds hundreds of different issues with different maturities, will inevitably offer greater protection against non-payment of interest and outright default than most individual investors could achieve on their own.
In addition to the advantage of diversity, open-ended bond mutual funds also have greater liquidity than individual issues. Redeeming shares in a bond fund is much easier than selling an individual bond. And investors who do not need cash flow benefit from bond funds because dividends are reinvested automatically.
Should junk, or hi-yield bonds be in your portfolio?
Most successful investors practice some form of risk management. An easy way to manage risk is to allocate assets to both stocks and bonds because nobody knows if stocks or bonds are going to out-perform in the near or far future. If stocks go down, then prudent investors buy more and vice versa. The problem is that you need money to buy anything. If stocks go down and if you hold a bond fund, then you can sell some of the shares of the bond fund to buy more stocks. So the first question is: What would you rather hold during a decline: junk bonds or hi-quality bonds?
During a modest decline, the supply of money available to business is generally going to increase because corporations are reluctant to borrow money. Intermediate and long-term interest rates are generally going to fall as a response to the increased money supply. The Fed generally helps by reducing short-term rates to encourage this virtuous cycle. That means, all other things being equal, the principal value of a bond fund is going to rise.
But all other things are almost never equal because many bonds are going to default during a decline. Most of the defaulting bonds are going to be junk, so the principal value of a junk bond fund is going to be compromised much more than the principal value of a hi-quality bond fund. Even if bonds do NOT default, there may be a crisis in confidence which may result in a flight to safety. No one knows exactly what a flight to safety ultimately means, but during the global crisis that manifested itself most severely during the fourth quarter of 2008, it meant that investors abandoned almost everything except US government bonds. Here's what happened to bond fund returns over the twelve months ending December 31, 2008:
Junk Bonds lost 21.3%
Investment Grade Intermediate Term Corporate Bonds lost 6.2%
Intermediate Term Bond Index gained 4.9%
Intermediate Term US Treasuries gained 13.3%
Long Term US Treasuries gained 22.5%
What about the growth phase? During a growth period interest rates are going to rise because corporations want to borrow money to expand. That means the PRINCIPAL value of ANY bond fund is going to tend to decline. That’s good, because a prudent investor will be selling stock during this phase because stocks will have risen in price. So, what should you, as a prudent investor, buy? If you buy junk, and if the economy stays healthy, then stocks will almost certainly out-perform junk. If the economy declines, then hi-quality bonds will almost certainly out-perform junk. Hmm, I wonder why it’s called junk.
Recommendations
Before the 2008 meltdown I recommended a bond portfolio consisting exclusively of the Vanguard Intermediate Term Bond Index Fund. Unfortunately, during the height of the crisis in November 2008, the Vanguard Intermediate Term Bond Fund lost principal value while interest rates were falling. However, Short, Intermediate, and Long Term Treasuries all rose in value during this crisis. So, as long as the government doesn't devalue its currency completely, that means that the best vehicle to own during a crisis is one the government controls, because the government prints money. There is, of course, always a chance that the government will devalue its currency completely, but I do not believe there's too much a normal person can do to protect oneself under these circumstances, so I am not going to consider alternatives herein.
In December 2008 the Vanguard Intermediate Term Bond Fund bounced back, but the lesson learned from this crisis is that the best bonds to own during a crisis are the bonds that are sold by the folks who print money. The following bond portfolio did well during the crisis AND it will probably outperform the Intermediate Term Bond Index Fund during the good times:
One third Vanguard Inflation Protected Securities (ticker VIPSX)
One third Vanguard Intermediate Term Treasuries (ticker VFITX)
One third Vanguard Intermediate Term Investment Grade (ticker VFICX)
One caveat: Now is NOT a good time to buy treasuries. Wait until spreads between treasuries and corporate bonds disappear and wait until interest rates start rising. In other words, buy stocks while interest rates are falling.
Revised January 2009