Over the past 30 years, high-grade corporate bonds have yielded an average of 7.14% nominally. During that same period, inflation ran roughly 2.90%. That means average real results - your increase in purchasing power as an investor - was roughly 4.24% before taxes and fees. This period covered a wide range of bond investment environments, including the soaring nominal rates of 13.77% in June of 1984 and the rock-bottom nominal rates of 3.04% in November of 2012.
The chart below shows the difference between the bond yield and the inflation rate from the year 2000 through today.
If you held the bonds as ordinary, taxable investments, and you earned quite a bit of money, a massive portion of your real return was destroyed. Depending on the state where you resided, your worst-case scenario could mean dropping your real return to 1.93% as the government, either in the form of taxes or inflation, stole your rewards from you. Had you held the bonds in a tax shelter, such as a retirement account or pension plan, you were able to enjoy it all.
Still, even under a dreary scenario, collecting checks that exceeded the inflation rate by 193 basis points was no small accomplishment. You had a legally enforceable contract that, if not honored, entitled you to sue the business in bankruptcy court and take precedence over the preferred and common stockholders. If you were so conservative as to insist on first mortgage bonds or other senior securities, you very well may have had tangible assets backing the bonds that practically guaranteed you'd come out whole, or at least close to whole, in the event of a liquidation. Meanwhile, you were able to go on with your life as money showed up in the mail from the corporations to which you had lent funds.
What Are Some Drawbacks?
There is no such thing as an "average" investment. Depending on where you fell relative to the mean trend line, your results were either far better or far worse. Bond investing is just as much about the opportunistic acquisition as common stock investing.
To illustrate: If you had realized that corporate earnings yields on stocks were a fraction of bond yields back in the late 1990s (which was no great secret as some of America's foremost academics and executives were practically screaming about it in editorials and interviews, or which you, yourself, could have confirmed with less than a minute of math), you could have done very well by refusing to play the game and, instead, loading up on 10-year bonds. Over the subsequent decade, you enjoyed real returns exceeding inflation by 4% to 5% per annum; a wonderful result for the boring task of doing nothing but checking that your direct deposit had arrived. (Several years ago, you had to clip coupons and use them to claim your bond interest; these days, you don't even have to do that!) In fact, you could have crushed the S&P 500 by simply buying Series I savings bonds. That's because stocks were stupidly overvalued and your opportunity cost meant you would collect more cash from the bonds. And isn't that the entire point of investing? Collecting more and more cash over time? The price you pay for every dollar is extraordinarily important.
Three Things Bond Investors Should Consider When Structuring a Bond Portfolio
- First, it's important to realize that bonds have more than one job in your portfolio - they are not just there to generate interest income. In a very real sense, they serve as a backup source of semi-liquidity; a sort of rock against which your funds can moor during the maelstrom. If stocks ever experience quotation declines of 50% to 90%, as happened in the Great Depression of 1929-1933, the combination of short-to-intermediate bond duration and high credit ratings should be fine, provided there is ample diversification.
- Second, even when interest rates are at record lows, bond investors often don't experience the pain overnight, or even within a few years, as they are still locked into their much higher interest rates. This is why it is important to use a bond ladder strategy, which permits you to gently roll over your funds. This mitigates the volatility of various interest rate environments and averages out your results to something close to the mean trend line to the degree such a thing is possible.
- Third, you can never be certain what the future holds. What looks like inflation on the horizon might turn into deflation, in which case bonds are much better protection than most other asset classes. The defense against this unfortunate reality was laid out by Benjamin Graham generations ago when he recommended that investors never hold less than 25% of their funds in bonds, nor allow their bond allocation to exceed 75% of a portfolio's value. Interestingly, academic analysis done by some of the best business schools and financial institutions over the past few decades have proven that Graham may have been on to something because a portfolio of 25% bonds, under nearly all conditions, delivered mostly the same aggregate results of a portfolio of 100% stocks, but experienced far less volatility, with higher survivability during down markets when retirees had to make withdrawals to cover expenses.
Put even more simply, a serious bond investor might consider:
- Sticking to a combination of 1.) short-to-intermediate bond duration to minimize interest rate risk, and 2.) strong firms that enjoy a fortress-like balance sheet and income statement
- Using a bond ladder strategy
- Maintaining a bond allocation of no less than 25% of the portfolio value
It must be said that everyone has a different situation and it's important you discuss this with your own qualified financial advisor. You may have unique circumstances that make this approach a bad idea for your own family. At the very least, it lets you understand some of the most conservative approaches used by well-heeled bond owners who want to protect their family's net worth.