As the chief investment officer for an insurance company, a friend of mine oversees hundreds of millions of dollars in bonds. But in his personal portfolio, he shuns them completely.
"You're just not being paid to take the risk" that goes along with holding bonds these days, he tells me. Many other financial pros agree. In a recent survey of 300 global money managers conducted by the Chartered Financial Analysts association in Britain, four out of five respondents agreed that bonds were overvalued.
Their collective thumbs-down reflects the depressed—and depressing—state of bond yields. A 30-year Government of Canada bond is now paying less than 2% a year in interest. Buyers are locking up their money for a generation in exchange for a payout that probably won't even keep pace with expected inflation.
Factor in taxes and commissions, and bonds are a great way to erode your net worth. So should you expel them from your portfolio?
If so, you're rebelling against decades of investing practice. Financial advisers place most clients in portfolios that are 30% to 60% bonds. In theory, the steady, dependable flow of cash from conservative bonds acts as a buffer against the wild swings of the stock market.
However, that logic has become far less compelling in recent years. A 10-year Government of Canada bond that would have showered you with a 16% yield back in mid-1982 now offers a scant 1.4%. The immediate reward from buying a bond has shrunk to invisibility.
The long-term appeal is also hard to see. As investors bid up bond prices, the yields go down. But at some point—and it's not too far away from current levels—yields hit zero and the gains stop. There is no longer any reason for them to buy bonds, and bond prices stall. (Yes, some European countries have pushed some yields below zero, but that is a temporary aberration—there is a limited supply of investors who will line up to lose money.)
The worst bond scenario is the possibility that the North American economy comes up roses and central banks increase interest rates. Bond yields will climb and prices will tumble. Many investors who thought they were holding safe assets will suffer significant losses.
So is there any reason at all to hold bonds? Insurance companies do so because they need to match future income to future payouts.
For individuals, the logic comes down to disaster protection: Years of record low interest rates have propelled the price of every financial asset into the stratosphere. Bond prices may actually be less frothy than current stock valuations. If the economy were to hit the skids, bonds would fare better than stocks.
That's a fair but less than thrilling argument. So, we can sidestep possible stock market carnage by embracing what may be smaller losses in bonds? Well, hooray.
For now, my friend is taking refuge in cash and dividend stocks. In my own case, I've cut back on a traditional bond mix in favour of a selection of GICs, high-interest savings accounts and ETFs that hold emerging-market bonds (which are risky, but pay higher yields than Canadian ones, and may benefit from future currency gains). As bond yields languish, the question is why more people aren't looking at similar workarounds.