Most investors believe that owning bonds— also called fixed income securities, bond funds or exchange traded funds/ETFs—always de-risks an investment portfolio. But this is a very dangerous assumption. It’s time we understand the truth about bonds.
To get to the root of the matter, I spoke with Marlene Puffer, President and Chief Executive Officer of the Investment Division that manages the pension plans for more than 50,000 railroaders at Canadian National Railway. Marlene is a global bond expert. When I first met her nearly 20 years ago, she was known as the “Bond Lady of Bay Street.” Today, Marlene is still into bonds in a big way, overseeing billions of dollars in bond investments.
GGF: In Warren Buffett’s annual shareholder’s letter he wrote: “…it is a terrible mistake for investors with long-term horizons – among them, pension funds, college endowments and savings-minded individuals – to measure their investment ‘risk’ by their portfolio’s ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk.” Can you help the average investor understand his statement since it seems to go against the common beliefs about bonds?
Marlene: There are a few general principles. First, when you buy a bond it has a fixed coupon rate. When interest rates go up, the value or price of the bond goes down. Second, inherent in Warren’s quote is a question…what is the relationship between bond prices and stock prices? What he is saying is that in his view, bond prices and stock prices will tend to move together rather than in different directions. His view is correct under stressed market conditions for lower quality corporate bonds, but in normal markets, prices for stocks and bonds tend to move in opposite directions.
GGF: We learn a lot about the details of bond math in the CFA (Chartered Financial Analyst) program. One of the biggest challenges for advisers is explaining bonds in an accessible way. Can you give it a try? What does the relationship between stocks and bonds mean for investors?
Marlene: There are two main components to what makes bond prices move. First, we have the “risk-free rate” – this is just the daily government interest rates which tend to be higher for longer maturity bonds than for shorter maturities. The return on risk-free bonds tends to move in the opposite direction to stocks.
Second, in the case of corporate bonds, we have an additional component – the expected investment return, or additional yield, that reflects default risk, and is over and above the risk-free rate. Critically, this second component tends to move in the same direction as stock returns, especially for lower quality (high-yield) bonds, and particularly when market conditions are stressed.
GGF: Why does this matter? Isn’t it great to have a return that is higher than what we can earn on government bonds?
Marlene: Higher return potential always equates to higher risk. And in this case the return from investing in high-yield corporate bonds has two pieces to it, one of which is directly related to the stock market. Think about what that means for your overall portfolio risk – if stock prices drop significantly, the diversification you thought you had may disappear.
GGF: I think what you’re saying is that there is a big difference between investing in government bonds and investing in corporate bonds from a risk perspective?
Marlene: Yes, and the trouble is the media often lumps all categories of bonds together. You have to clarify what you are talking about! Government bonds and short-term, high-quality, corporate bonds do tend to have more stable prices and diversify a stock portfolio. But when you get into longer-term, or high-yield corporate bonds, their prices will move more like stock prices.
GGF: What is your advice for the average investor?
Marlene: The starting point in the current market environment is really challenging because, relative to historical reference points, both stocks and corporate bonds are expensive. These days, investors are not picking up much extra yield on a high-quality corporate bond over a government bond, so in order to get worthwhile yields they need to look at higher yield corporate bonds. The problem is, if stock markets drop then your high yield bonds will also perform badly.
Marlene’s Advice on Investing in Bonds:
- If you are going to invest in bonds, stick with short-term, that is, fewer than five years to maturity, and investment grade, BBB-minus or higher. How much to have in your portfolio depends on how much downside risk you can tolerate from your stock portfolio;
- Stay well-diversified globally for stocks;
- Know how much you are paying for your investment advice – beware of bond funds with relatively high management expense ratios. (Although the average bond mutual fund expense ratio is lower than the average equity fund expense ratio, within the bond category there is a range of expenses, with some being high enough to wipe out a lot of the yield);
- Know what you are buying. *
*On that last point, if you are a very wealthy investor and have access to lower institutional trading costs, you may prefer to hold a laddered portfolio of individual bond issues. (Bonds maturing at 1, 3, 5, 7 and 10 years, for example). For average investors, your next best option is a passive, low expense ratio, exchange-traded fund that holds short- to medium-term bonds with a maximum maturity of 5 years.