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Are Bonds Bad for Your Financial Health?

Warren Buffett says to avoid them — but is he right?

U.S. EE savings bond closeup

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En español | In his recent Berkshire Hathaway shareholder's letter, the Oracle of Omaha — and Berkshire CEO — warns against owning bonds. Should you follow his advice? Here's my take, along with some ideas about how to safely earn more on the portion of your portfolio devoted to bonds.

Regarding bonds, Warren Buffett's letter reads as follows:

"And bonds are not the place to be these days. Can you believe that the income recently available from a 10-year U.S. Treasury bond – the yield was 0.93 percent at year-end – had fallen 94 percent from the 15.8 percent yield available in September 1981? In certain large and important countries, such as Germany and Japan, investors earn a negative return on trillions of dollars of sovereign debt. Fixed-income investors worldwide — whether pension funds, insurance companies or retirees — face a bleak future."

Though rates are low, it's not a bleak as you might think. As Buffett points out, rates were quite high in the late ‘70s and early ‘80s, with the 10-year Treasury yielding an average of 12.3 percent in the three-year period from 1979 to 1981. But tax rates were as high as 70 percent then, and even if only a third went to taxes, the after-tax yield averaged 8.2 percent. Unfortunately, inflation averaged 11.9 percent, so one lost about 3.7 percent of their spending power. Simply put, real rates — adjusted for inflation and taxes — were worse back then.

Perhaps a larger concern is that rates will rise. Rising rates cause the principal value of bonds to decline. Indeed, the rate on the 10-year Treasury has risen from 0.93 percent at the end of the year to 1.62 percent as of March 16. This caused an intermediate-term, high-quality bond fund like the iShares Core U.S. Aggregate Bond ETF (AGG) to lose more than 3.3 percent this year. If rates continue to rise, bonds will have more losses. But remember two things.

  • Economists have a horrible track record of predicting interest rates.
  • If rates do rise, the silver lining is your bonds will yield more.

While I'm not in complete agreement with Warren Buffett on avoiding bonds, I wholeheartedly endorse his advice not to buy low credit quality bonds. Buffett says:

"Some insurers, as well as other bond investors, may try to juice the pathetic returns now available by shifting their purchases to obligations backed by shaky borrowers. Risky loans, however, are not the answer to inadequate interest rates. Three decades ago, the once-mighty savings and loan industry destroyed itself, partly by ignoring that maxim."


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My advice

Remember that pension plans, insurance companies and investment firms like Berkshire Hathaway have much longer lifespans than humans. Billionaires don't have to worry much about a stock market plunge like the rest of us do.

Thus I'm keeping my asset allocation at 55 percent in fixed income, with all in high credit quality securities, because I want this money to last as long as I do. (Fixed income, in Wall Street parlance, means any investment that makes regular interest payments, such as bonds, bank CDs and even money market mutual funds.) Stocks are risky. Compare the 3 percent loss in bonds so far this year with the nearly 13 percent loss in stocks in one day last year. And don't count on stocks always recovering quickly. It took over 30 years for stocks in Japan to recover from their high in 1989.

As I mentioned, I'm keeping my asset allocation at 55 percent fixed income and 45 percent stocks. For me, however, only about half of my fixed income is in bond funds. Other places to stash your safe cash include:

  • Higher-yielding savings accounts or CDs backed by the FDIC (bank) or NCUA (credit union). Depositaccounts.com and Bankrate.com are two good places to find them.
  • A stable value fund in an employer's retirement plan, such as a 401(k) or a 403(b).
  • Many TIAA employer plans have a legacy stable value option yielding a minimum of 3 percent, though be sure to read the fine print.
  • Pay down your mortgage. When you buy a bond, you buy a loan — typically to a company, the U.S. government, or state and local governments. A mortgage is a loan, too, and paying down your mortgage is the inverse of a bond. Money you are not paying the bank is the equivalent of what you are earning. You may not be getting much of a tax benefit from your mortgage, so paying down a 3 percent mortgage could be the equivalent of a 3 percent risk-free and tax-free return.

Conclusion

You've worked hard to save and can now enjoy the fruits of your labor. The purpose of your fixed income is to be the safe money that allows you to spend on whatever brings you happiness. If you put it in stocks and stocks continue to soar, you may be only marginally happier. But if stocks tank, there will likely be severe consequences for your lifestyle. Consider what you'd have to give up if stocks lose 60 percent of their value and don't recover before you exit fixed income.

Allan Roth is a practicing financial planner who has taught finance and behavioral finance at three universities and has written for national publications, including The Wall Street Journal. Despite his many credentials (CFP, CPA, MBA), he remains confident that he can still keep investing simple.

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