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Graham Westmacott CFA

Portfolio Manager

Susan Daley CFA

Associate Portfolio Manager
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  • 1.877.517.0888
  • F519.880.9997
  • The Marsland Centre
  • 20 Erb St. W,
    Suite 506
  • Waterloo, Ontario N2L 1T2

Why Buy Bonds?

August 20, 2013 - 0 comments

Investors who want only winners in their portfolio do not have a winning strategy. The current debate about falling bond prices is a timely illustration.

We all expect interest rates to rise and bond prices fall as interest rates rise. So, why buy bonds?

Tennis anyone?

To answer this question we would point to an article1 written 37 years ago by Charles Ellis called “The Loser's Game”. Famously he pointed what some people still refuse to accept, despite nearly four decades of evidence. Ellis drew a parallel between investing and tennis. Most people lose at tennis through unforced errors trying to despatch the opposition with an ace serve or a stunning cross court volley that ends up on the wrong side of the line. Too many risks are taken that do not pay off. In contrast, the successful tennis player keeps the ball in play until her opponent makes a mistake.

Building wealth is similar. Success comes not from buying a bunch of stocks and hoping that winners exceed losers. Success comes from addressing the risks that may threaten the value of your investments and then capturing what the markets offers. Specifically,

- capitalism is about providing capital to firms that produce profits that not only repay shareholders and debtors but also allow for re-investment.  In the jargon, investing has to have a positive expected return for capitalism to function.

- investors will get their return, if they don’t make unforced errors.

- unforced errors arise from exposure to risks that could have been avoided at no, or at least a modest, cost. 

Investing in a few stocks, when equity diversification is easily achievable though index funds or ETFs, is an obvious example of risky behaviour. Other risks include the risk of inflation eroding portfolio purchasing power, the risk of companies becoming unable to repay their debts, the risk of large scale economic recession, and the risk of changes in interest rates, to name a few. By blending different asset classes we build a robust portfolio in anticipation of the stresses it will be subject to. On this subject, Ellis, in a more recent article, quotes from the Chinese general Sun Tzu’s Art of War “The skillful commander takes up a position so he cannot be defeated. Thus a victorious army wins its victories before the battle”. As Ellis points out, war is the ultimate Loser’s Game.

Bonds keep you in the game

This brings us back to the role of bonds. To think of bonds entirely in terms of their prospects for either short term returns as an asset class, or as a contributor to the overall portfolio return, is to miss their key role in protecting against downside risk.

By way of illustration, we compared a 40% bond, 60% globally diversified equity portfolio with a 100% equity portfolio since 1994 (the longest available data for the portfolio we chose3). The bonds:

  • reduced the final value of the portfolio by 5%
  • reduced the overall portfolio volatility by 38%
  • reduced the worst fall in value over 1 year by 39%
  • reduced the worst fall in value over 3 years by 52%

For a modest (5%) reduction in final wealth, the bonds provided significantly better downside protection when the portfolio was under the most stress. This is a worthwhile trade-off for most investors, but particularly for those in retirement who want to draw a steady income from their portfolios.

To illustrate, we considered the case of Alice and Bob who each had a retirement portfolio of $500,000 at age 65 and wanted to withdraw $30,000 annually until age 90. Alice was 100% invested in global equities while Bob chose to invest 40% in bonds and 60% in global equities, as in our previous example. Despite the higher average annual return of Alice’s equity portfolio (8.53%) compared with the Bob’s portfolio return of 7.72%, the chances of Bob’s portfolio surviving to age 90 is actually higher than Alice’s due to the countervailing impacts of lower portfolio volatility and better downside protection from the bonds.

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Notes
  1. The Loser’s Game, Charles Ellis, Financial Analysts Journal, Vol 31, #4, July/August 1975
  2. Lessons on Grand Strategy, Charles Ellis, Financial Analysts Journal, Vol 69, #4, July/August 2013
  3. The 40% bond portfolio was represented by 40% DEX Global Bond Index and 60% DFA Global Equity index. The 100% equity portfolio was represented by 100% DFA Global Equity Index. For Alice and Bob’s retirement simulation we assumed a $30,000 annual withdrawal and a 1% management fee.  
By: Graham Westmacott with 0 comments.
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