Thursday, May 23, 2013

Disagreement over Investing in Bonds

According to CNBC, Warren Buffet “said that bonds are a ‘terrible’ investment right now because they are ‘priced artificially’ high ... and could lose people a lot of money when inevitably interest rates start to rise.” Chartered Financial Analyst Steve Lowrie says he disagrees with Buffett, but I think the two are actually talking about different things.

Buffett says he believes that interest rates are set to rise at some point and this will hurt bond prices. This is a statement about expected bond returns over the next few years. Buffett makes no claims about the volatility of bonds, just that their expected returns are poor.

Lowrie objects that investors have a limited capacity for risk and cannot handle an all-stock portfolio. This is true of most investors. However, Lowrie is talking about the volatility of bonds (specifically that it is lower than the volatility of stocks); he is not talking about bonds’ expected returns as Buffett was.

Investors who believe both Buffett and Lowrie can use GICs (or very short-term bonds) for the fixed income part of their portfolios. This avoids the upcoming hit to bond prices that Buffett predicts and avoids increasing portfolio volatility that Lowrie says investors cannot handle.

Apparent disagreement resolved.

11 comments:

  1. Bonds seem to have some volatility recently. I looked at XBB for example and it's had swings of 2-3%, both up and down, over periods of a few weeks or months.

    If the long-term returns of short-term bonds looked anywhere near reasonable I would probably not be all in stocks right now.

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    1. @Value Indexer: I'm all in stocks right now as well. However, I based this decision on the long-term performance of bonds rather than the near future (which appears to be quite dismal, but I don't trust my judgement on these matters).

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  2. Using the neat InvestSpy.com calculator, we find that XBB (bond universe ETF) has a trailing one-year volatility of 3.3% while XSB (short bond ETF) is half that at 1.6%. For the whole time period available back to Aug 2001, XBB's annualized volatility is 5.3% while XSB's is 3.6%, not half but still a lot less. Meanwhile XIC (TSX Composite ETF) had a volatility of 17.9%. The tool really helps show how bonds drastically reduce portfolio volatility, partly because they themselves have less volatility but also because they have low correlation to equities.

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    1. @Canadian Investor: I think it's dangerous to look at volatility figures over such short time periods, but you'll get similar results over longer periods.

      It's important to look at expected returns rather than just volatility. For example, simply giving your money away has a volatility of zero, but the expected return is dismal.

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  3. Bonds suck as an investment. If inflation is 3% and bonds are returning 2.5%, then you're actually losing money investing in bonds. That's why one must invest in equities over the long term.

    The only reason to invest in bonds is as part of an asset allocation mix. Because bonds are inversely correlated (or non correlated? I forget) with equites, when markets crash your funds in bonds remain untouched. You can then rebalance your portfolio, moving money from bonds back into equities after crashes/dowturns. Then as equities return, you can rebalance money back from the markets over to bonds, in preparation for the next downturn. That's it. Using bonds as because they're 'safe' is a bad idea.

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    1. @Glenn: Inverseley-correlated would be wonderful, but the best you can hope for over the long term is roughly uncorrelated. You've captured my thinking about my own portfolio, but there are many investors who will do drastic and terribly damaging things like sell to cash in the face too much volatility. They need some way to avoid such emotional mistakes. So, I'm sympatheitc to the need to reduce volatility. However, this can be achieved with GICs rather than bonds.

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  4. I would much rather invest in a preferred share ETF (like CPD) . I realize that preferred are slightly more risky than bonds, but sticking new money in bonds at a time when their value is at it's highest would not fly in my portfolio.
    At least in CPD i'm getting 4.5%.

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    1. @Chris B.: I've never looked into the volatility of preferreds. I don't know if they would serve well to reduce the volatility of a portfolio.

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  5. "Bonds suck as an investment."

    I had to laugh at that....

    Yeah, I don't have much in bonds. Some, but not much. I figure as long as I have a pension, and more years I've paid into it, I don't need them.

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    1. @Mark: It's amazing how things change. For many years, bonds were a fantastic investment (while interest rates were dropping). Now it's hard to imagine any future where bonds make money.

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  6. There is a time and place for almost most investment 'products'. Now is not the time to go out and buy a bunch of bonds.

    The typical 'bond' investor makes the classic mistake of confusing volatility with risk. Today, bonds are not very volatile - but they are certainly risky.

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