Bonds: The Bare Bones
July 14, 2023
Bonds have long been touted as a vital asset class for the average investor’s portfolios. Figures like 60% stocks and 40% bonds are prescribed as allocation requirements for “balanced” investors. In fact, Vanguard even named a 60/40 fund based on that perception, the Vanguard Balanced Index Fund Shares (VBINX). Bonds have performed terribly in the recent couple of years. With interest rates significantly heightened from the near-free money being offered only a couple of years ago, bond prices have been hit significantly. Morningstar found that core bond funds took their biggest hit since 1999, 13 percent.
Despite recent bond returns disappointing many investors, many still strongly advocate for their place in portfolios, especially closer to retirement with lesser risk tolerance. Since 2000, The Bloomberg U.S. Aggregate Bond Index has performed with an annualized return of 4.1%, lagging the S&P 500’s annual return of 6.6% for the same period. Those annualized returns do not tell the whole story, however.
A backtest, starting in 2000, of a $1,000,000 retirement portfolio withdrawing $3,000 per month (adjusted for inflation) actually saw a 100% bond portfolio hold a slightly higher balance by the end of June 2023 than a 100% stock portfolio invested over the same period. The 23-year period involved some severe drawdowns for stocks. Still, withdrawals had to continue despite depressed stock prices as the simulated is a retirement calculator. The withdrawals in bad times outweighed the higher annual return for stocks (which this simulator found compared at a compounded annual growth rate of 6.91% for U.S. stocks and 3.79% for U.S. bonds). The stability bonds offer can make up for their lower returns.
The bond market is huge in the United States, unsurprising considering the position of bonds as one of the hallmarks of a balanced portfolio. The World Economic Forum calculates the U.S. bond market as worth around $51 trillion. With hopes that declines in inflation will compel the Federal Reserve to bring down interest rates in the near-enough future, the returns within that market may improve (Of course, Federal Reserve’s interest rate decisions will likely be the ultimate factor in whether that happens).
While on the surface, the lagging returns of bonds, compared with the American stock market, do not make them particularly enticing investment choices, consideration of their historically less volatile movements may outweigh the returns lag for some investors. Not for Warren Buffett, however, who, in 2019, stated, “If I had a choice today for a 10-year purchase of a 10-year bond at whatever it is… or buying the S&P 500 and holding it for 10 years, I’d buy the S&P in a second.” When risk tolerance and withdrawals to cover retirement expenses are factored in, though, there is reason to seriously consider the safety of bonds. As with any personal finance decision, it is up to each investor to make allocation determinations based on their priorities and risk tolerances, but being informed is the foundation needed to do so.