Tuesday, October 27, 2020

Owning Today’s Long-Term Bonds is Crazy

Today’s long-term bonds pay such low interest rates that it makes no sense to own them.  There is virtually no upside, and rising interest rates loom on the downside.  Warren Buffett called this “return-free risk.”  He was right.  Here I explain the problem and address objections.

As I write this, 10-year Canadian government bonds pay 0.623% interest.  If you invest $10,000, you’ll get a total of only $623 in interest over the decade, and then you’ll get your $10,000 back.  This is crazy.  Even if inflation stays at just 2%, you’ll lose $1237 in purchasing power.

Even worse are 30-year Canadian government bonds that pay 1.224% as I write this.  Your $10,000 would get a total of $3672 in interest over 3 decades.  This is a pitiful amount of interest over a full generation.  At 2% inflation, you’ll lose $1738 in purchasing power.  Even a portfolio that only beats inflation by 2% per year would gain $8113 in purchasing power over 30 years.

All investments have risk, but there has to be some potential upside to justify the risk.  Where is the upside for long-term bonds?  The only upside comes if we have sustained deflation.  It’s crazy to risk so much just in case the prices of goods and services drop steadily for the next decade or three.

Some investors mistakenly think they can always sell bonds and collect accrued interest.  That’s not how it works.  With a 30-year bond, the government is promising to pay you the tiny interest payments and give you back your principal after 3 decades.  If you want out, you have to sell your bond to someone else who will accept these terms.  You don’t get accrued interest; you get whatever another investor is willing to pay.  Counting on selling a bond is hoping for a greater fool to bail you out.  If future investors demand higher interest rates on their bonds, your bond will sell at a significant capital loss.

If the interest rate on 30-year bonds goes up over time, that’s actually bad for current bond owners, because they have to live with their lower rate instead of receiving the new rate.  If 30-year bond interest rates go up by 1%, you immediately lose 30 years of 1% interest; you can’t just sell to avoid the loss because other investors wouldn’t happily take these losses for you.

Let’s go through some objections to this argument against owning today’s long-term bonds.

1. Stocks are risky.

It’s true that stocks are risky, but I’m not suggesting that investors replace long-term bonds with stocks.  Short-term bonds and high-interest saving accounts are safer alternatives.  A decision to avoid long-term bonds doesn’t have to include a change in your asset allocation between stocks and bonds.  For anyone willing to look beyond Canada’s big banks, it’s not hard to find high-interest savings accounts paying at least 1.5% and offering CDIC protection on deposits.  If long-term bond interest rates ever return to historical norms, it’s easy to move cash from a savings account back into bonds.  So, you don’t have to live with a measly 1.5% forever.

2. Investors need to diversify.

The benefit from diversifying comes from owning assets with similar expected returns that aren’t fully correlated.  However, the expected returns of today’s bonds are dismal.  We don’t really own bonds for diversification these days.  The real reason we own bonds is to blunt the risk of stocks.  It doesn’t make sense to try to reduce portfolio risk by buying risky long-term bonds.  Flushing away part of your portfolio with long-term bonds isn’t a reasonable form of diversification.  Short-term bonds and high-interest savings accounts do a fine job of reducing portfolio volatility without adding significant interest rate risk.

3. Long-Term bonds have higher interest rates than short-term bonds.

Historically, long-term bonds rates usually have been higher than short-term rates.  Today, however, high-interest savings accounts pay more interest than long-term government bonds.  But that’s not the only consideration.  Interest rates will change over the next 30 years.  If you own short-term bonds, your returns will change too.  However, if you buy 30-year bonds, your interest rate won’t change for 3 decades.  If interest rates rise, new short-term bond rates will be higher than your old 30-year rate.  Even if long-term bond rates rise, that won’t change your interest rate.  New investors will get more interest, but your bonds will still be locked into the same low rate.

4. All durations of bonds have done very well for almost 40 years.

Interest rates peaked in 1981 and have declined steadily since then (with some bumps along the way).  Investors who bought bonds that paid high interest rates have been able to sell them at a premium because their high interest payments keep looking better as interest rates on new bonds decline.  Unless you believe interest rates can go negative to -10% or lower, the next 40 years can’t look the same.  If interest rates ever return closer to historical norms, long-term bonds will get clobbered.  

5. My favourite ETFs contain long-term bonds.

Almost all balanced funds and bond funds contain some long-term bonds.  My favourite ETF company is Vanguard because of their focus on treating investors well.  Vanguard Canada has a great lineup of asset allocation ETFs that allow investors to buy just one ETF for their whole portfolio.  Unfortunately, these asset allocation ETFs, including the new retirement income ETF called VRIF, contain long-term bonds.  I’d like these products a lot better if the only bonds they held were short term.

Concluding Remarks

Throughout history, it has made a lot of sense to own a diversified set of stocks along with government bonds of various durations.  Looking back in time, we recognize stocks bubbles, but I’ve never been sure I was in a stock market bubble while it was happening.  So, I’ve maintained my allocation to stocks through thick and thin.  But it’s not hard to see the problem with long-term bonds today.  They have plenty of downside possibilities with almost no upside.

Unfortunately, almost all simple balanced investment options for Canadians include long-term bonds.  The simplest reasonable investing solution I see for a do-it-yourself Canadian is to own Vanguard Canada’s VEQT for the stock allocation, and place the fixed income allocation in short-term government bonds or high-interest savings accounts (not from a big bank).  For those using advisors, good luck convincing your advisor that long-term bonds aren’t worth owning.

None of this is intended as investment advice.  I spend time thinking and writing about how to invest my own money.  I’ve always preferred to keep my fixed income investments liquid, and I’m more certain than ever that I don’t want to own long-term bonds.

Monday, October 26, 2020

The Elements of Investing

When it comes to what really works in investing, two of the greats are Burton Malkiel (author of A Random Walk Down Wall Street) and Charles Ellis (author of Winning the Loser’s Game).  They came together to write the short book The Elements of Investing that leaves out “complex details that tend to overwhelm normal people.”  This book is full of excellent ideas that Canadians can apply, although the most detailed advice is U.S.-centric.

The elements of investing the authors chose are save, invest in indexes, diversify, avoid blunders, and keep it simple.  We all know that saving is easier said than done.  I was pleasantly surprised at the practical ideas on saving rather than just preachiness.

“Because they center their thinking on enjoying the benefits of achieving their goals, most savers and most slim people take pleasure in the process of saving and the process of keeping trim.  They do not think in terms of deprivation.”  “You can too.”

For couples, “practice ‘double positive’ shopping”: “agree that nothing gets purchased without both of you saying yes.”

“The only sensible limit on credit card debt is zero.”  “Every month or two, go over your expenditures, including credit card charges.”  Think about whether the purchases were all equally worthwhile, or whether you could easily have done without one of two of them.

The authors consider owning a home to be part of saving.  Under normal circumstances I would agree, but housing prices in big Canadian cities have run away from rent levels.  Parts of the authors’ reasoning about owning a home doesn’t apply in Canada.  “Your bank will not let you borrow more than you can sensibly handle given your income.”  This isn’t true here.  They also point to U.S. mortgage tax deductions which don’t exist in Canada.

The second chapter gives an excellent summary of the case for index investing, without the technical detail.  The authors explain that “The average actively managed mutual fund charges about one percentage point of assets each year for managing the portfolio.”  The case is even stronger in Canada where typical costs are 2% or higher.  These costs build up over an investing lifetime to consume one-third to half of a portfolio.

I liked the explanation of why market forecasters are useless.  “For a market forecaster to be right, the consensus of all others must be wrong and the forecaster must determine in which directionup or downthe market will be moved by changes in the consensus of those same active investors.”

On the subject of asset allocation, the authors make an interesting point about bequests.  “The appropriate allocation for planning bequests should be geared to the age of the recipient, not the age of the donor.”  So, even if you’re 90, the part of your portfolio you’re leaving to your grandchildren should be in stocks.

The authors each offer separate ideas on how your portfolio should become less risky as you age.  Ellis is more aggressive, suggesting still having 30-50% in stocks at age 80.  My own plan based on maintaining 5 years of spending in fixed income is more aggressive than either author, but my plans probably aren’t suitable for most people.

The book contains specific recommendations for mutual funds and exchange-traded funds (ETFs).  Canadians can’t buy U.S. mutual funds, and most Canadians prefer to avoid the currency exchanges necessary to buy ETFs in U.S. dollars.  However, it’s not too hard to find Canadian ETFs that meet the criteria the authors laid out for choosing investments.

Overall, I found this short book contains great investment advice.  I wish I had known these things decades ago before I made many mistakes.  Life is a great teacher but the tuition is very expensive.  This book can save investors a lot of money.

Friday, October 23, 2020

Short Takes: Invisible Progress, Probate Fees, and more

This has been a week of IT fixes for me.  I’ve been fixing broken links on the blog and trying to keep the family printer/scanner working.  For a long time we’ve been able to print but not scan from my wife’s laptop.  But on my laptop, I could only scan and not print.  So we sent messages back and forth (“please print this pdf” and “here’s the scan you wanted”).  Finally, after an HP Smart app “update,” scanning stopped working for me too.  Several hours of fruitless attempts to install an updated printer driver led me to try the Windows scan app to access the scanner.  It seemed to work at first, but it produces comically large files because it thinks the paper is 23x32 inches (you can’t make this stuff up).  All this has left me planning to buy a new printer.  It seems silly to buy new hardware over a software problem, but that’s where I am.

Here are my posts for the past two weeks:

Financial Warning Signs

Variable Percentage Withdrawal: Garbage In, Garbage Out

Here are some short takes and some weekend reading:

Morgan Housel explains why progress is a yawn while disasters grab our attention.

The Blunt Bean Counter discusses pitfalls with two popular ways of trying to avoid probate fees.

Justin Bender explains (in a video) how ETF investors can take advantage of tax-loss harvesting without getting hit by CRA's superficial loss rule.  Canadian Couch Potato covered the same subject in written form.  Both are excellent sources of reliable investment information.

Boomer and Echo addresses major gaps in your retirement plan.

Doug Hoyes explains why we shouldn't obsess over our credit scores in this short video.

Big Cajun Man explains some of the rules around turning your RDSP (Registered Disability Savings Plan) into a SDSP (Specified Disability Savings Plan).

Tuesday, October 20, 2020

Variable Percentage Withdrawal: Garbage In, Garbage Out

The concept of Variable Percentage Withdrawal (VPW) for retirement spending is simple enough: you look up your age in a table that shows what percentage of your portfolio you can spend during the year.  The tricky part is calculating the percentages in the table.  Fortunately, a group of Bogleheads did the work for us.  Unfortunately, the assumptions built into their calculations make little sense.

If we knew our future portfolio returns and knew how long we’ll live, then calculating portfolio withdrawals would be as simple as calculating mortgage payments.  For example, if your returns will beat inflation by exactly 3% each year, and your $500,000 portfolio has to last 40 more years, the PMT function in a spreadsheet tells us that you can spend $21,000 per year (rising with inflation).

Instead of expressing the withdrawals in dollars, we could say to withdraw 4.2% of the portfolio in the first year.  If the remaining $479,000 in your portfolio really does earn 3% above inflation in the first year, then the next year’s inflation-adjusted $21,000 withdrawal would be 4.26% of your portfolio.  Working this way, we can build a table of withdrawal percentages each year.

Of course, market returns aren’t predictable.  Inevitably, your return will be something other than 3% above inflation.  You’ll have to decide whether to stick to the inflation-adjusted $21,000 or use the withdrawal percentages.  If you choose the percentages, then you have to be prepared for the possibility of having to cut spending.  If markets crash during your first year of retirement, and your portfolio drops 25%, your second year of spending will be only $15,300 (plus inflation), a painful cut.

A big advantage of using the percentages is that you can’t fully deplete your portfolio early.  If instead you just blindly spend $21,000 rising with inflation each year, disappointing market returns could cause you to run out of money early.

Choosing Withdrawal Percentages

One candidate for a set of retirement withdrawal percentages is the RRIF mandatory withdrawals.  These RRIF withdrawal percentages were designed to give payments that rise with inflation as long as your portfolio returns are 3% over inflation.

Unfortunately, the RRIF percentages would have a 65-year old spending only $20,000 out of a $500,000 portfolio.  Some retirees chafe at being forced to make RRIF withdrawals, but when it comes to the most we can safely spend in a year, most retirees want higher percentages.

A group of Bogleheads calculated portfolio withdrawal percentages for portfolios with different mixes of stocks and bonds.  Most people will just use the percentages they calculated, but they do provide a spreadsheet (with 16 tabs!) that shows how they came up with the percentages.

It turns out that they just assume a particular portfolio return and choose percentages that give annual retirement spending that rises exactly with inflation.  You may wonder why this takes such a large spreadsheet.  Most of the spreadsheet is for simulating their retirement plan using historical market returns.

The main assumptions behind the VPW tables are that you’ll live to 100, stocks will beat inflation by 5%, and bonds will beat inflation by 1.9%.  These figures are average global returns from 1900 to 2018 taken from the 2019 Credit Suisse Global Investment Returns Yearbook.  

So, as long as future stock and bond returns match historical averages, you’d be fine following the VPW percentages.  Of course, about half the time, returns were below these averages.  So, if you could jump randomly into the past to start your retirement, the odds that you’d face spending cuts over time is high.  

For anyone with the misfortune to jump back to 1966, portfolio spending would have dropped by half over the first 14 years of retirement.  More likely, this retiree wouldn’t have cut spending this much and would have seriously depleted the portfolio while markets were down.

The VPW percentages have no safety margin except for your presumed ability to spend far less if it becomes necessary.

Looking to the Future

But we don’t get to leap into the past to start our retirements.  We have to plan based on unknown future market returns.  How likely are returns in the next few decades to look like the average returns from the past?

30-year bonds in Canada pay less than 1.2%.  For them to beat inflation by 1.9%, we’d need to have 30 years of 0.7% deflation.  That’s not impossible, but I wouldn’t count on it.  It seems crazy to expect bonds to deliver 1.9% annual real returns in the coming decades.  Bond returns may get back to historical averages at some point, but retirees can’t expect much for some time.

Expecting 5% annual real returns from stocks may be sensible enough, as long as you have a high capacity for reducing retirement spending if it becomes necessary.  If your ability to reduce retirement spending is more limited, you need a safety margin in your assumed stock returns.  For my own retirement spending plans, I use inflation+4% for stocks (minus investment costs) and inflation+0% for bonds.

If we recalculate the VPW tables with these new assumptions, the annual withdrawal percentages drop by nearly a full percentage point.  This may not sound like much, but let’s look at an example of a 65-year old spending from a $500,000 portfolio invested 50% in stocks and 50% bonds.  The “official” VPW tables would have this retiree spending $25,000, but only $21,000 by my calculations.  It’s not hard to see who most retirees would rather believe.


This disagreement over reasonable assumptions makes a big difference for pre-retirees deciding how much money they need to retire.  For the 65-year old in the earlier example wanting to spend $25,000 per year, the Bogleheads say to save $500,000, and I say nearly $600,000.

Clearly I could never make it as a financial advisor.  I’d be worried about protecting people from future spending cuts, and more “optimistic” advisors would scoop up all my clients by telling them what they want to hear.


Even when smart people develop good retirement spending tools, the results are only as good as the baked-in assumptions.  We can’t count on the high bond returns of the past, and it makes sense to have some safety margin in expected stock returns.  As with so many other calculators, if you input garbage assumptions, the results you get out will be garbage as well.

Tuesday, October 13, 2020

Financial Warning Signs

I recently saw the headline Five warning signs you are in over your head financially, by Pattie Lovett-Reid.  I saw it as an opportunity to learn more about how to help people avoid financial trouble.

Here is a summary of her list of warning signs:

  1. You are ignoring your finances.
  2. Your finances are giving you a lot of anxiety.
  3. As soon as you get paid, all of your money is spoken for, with the majority of it going to debt service.
  4. Your creditors are calling non-stop.
  5. You are borrowing from Peter to pay Paul.

I was expecting warning signs that you’re headed in a bad direction, but these seem to be signs that you’re already in serious trouble that will be difficult to fix.  In a similar vein, here are my warning signs that you’ve got health problems.

  1. Most of your blood is on the ground.
  2. You haven’t breathed in a few days.
  3. You’ve been cremated.

My point is that I was hoping for more subtle signs that your finances are heading in the wrong direction.  Catching the problem earlier makes it easier to fix.

Let’s go through some more early warning signs of potential financial problems.

You didn’t pay off all of your credit cards in full last month.

Does this mean all is lost?  Not at all.  It’s just a sign that you’re headed in the wrong direction.  If you’re on a trip and make a wrong turn, all you need to do is turn around; your trip isn’t ruined.

Suppose this is the first time you haven’t paid off your card in full.  The appropriate response is to make a plan to get it paid off.  Look for some way to reduce other spending until you’ve eliminated the credit card debt.

You don’t have any quick access to emergency funds without adding new debt.

If you don’t have an emergency fund, you’ll be fine as long as nothing bad ever happens.  Of course, bad things do happen, such as cars needing repairs, health expenses, etc.  Going further into debt for each of these problems is a formula for eventual bankruptcy.

Don’t despair if you have no emergency savings.  Just start saving a little at a time.  When you have enough of a cushion, stop adding to it.  If you ever have to dip into it, start adding to it a little at a time again.

You are about to sign a many year commitment to big payments.

This is most common when buying cars or houses that are too expensive, but there are other cases.  For example, an insurance salesperson might try to sell you on some complicated mix of life insurance and investments.  As long as you make the big monthly payments for decades, you’ll get millions in your retirement.  But what happens if you can’t make the payments at some point?  The answer is that you’ll lose the car, house, or retirement.  Make sure the payments you commit to are reasonable, even if you end up facing big changes in your life.

I’d be interested to hear about more early warning signs of personal financial trouble.  The idea is that the warning should come early enough to be able to solve the problem without too much pain.

Friday, October 9, 2020

Short Takes: Revisiting the 4% Rule, Vanguard’s new Monthly Income Fund, and more

Sharp-eyed readers might have noticed that I removed ads from my blog.  The income has been dismal for some time, and I was never really doing this for the blog income.  The deciding factor was that so many of the ads I saw on my blog were at odds with my messages.

I started writing because I wanted to learn more about investing and about personal finance in general.  With the help of readers I've made great strides, and I've been pleased to educate others while learning myself.

I wrote one post in the past two weeks:

Rebalancing When There are No Trading Fees

Here are some short takes and some weekend reading:

William Bengen, author of the original “4% rule,” revisits his work on safe retirement withdrawal rates.  (The paper appears to now be caught behind a paywall or sign-up.)  This paper is quite interesting, although it travels significantly into data-mining territory.  Here are a few things I wish he would consider in his analysis: longer retirements than 30 years, investment costs, and flexibility to reduce spending somewhat if necessary.

Canadian Couch Potato answers questions about Vanguard Canada’s new monthly income ETF with the ticker symbol VRIF.  His analysis of VRIF continues in a second post, and in the third he explains the ways VRIF is different from problematic monthly income funds.  In the last post of this series, Canadian Couch Potato explains which types of portfolios are suitable for VRIF.

John Robertson finds some problems with a proposal to try to save money unbundling all-in-one ETFs.

Justin Bender compares the gold ETFs IAU and GLD (in a video no longer online).  My favourite part came in an example with two hypothetical traders: “immediately after purchasing their shares, Wayne and Garth realize they just bought a hunk of metal that doesn’t do anything.”  I keep waiting for the world to figure out that gold’s price makes no sense compared to its value as a metal, and that the world’s major currencies are no longer backed by gold.  It’s like a huge game of hot potato where whoever is holding the gold when we all wake up loses.

The latest Rational Reminder podcast includes Jordan Tarasoff describing in detail how badly clients were treated at his previous financial advice firm.  The bad advice of the week that follows is entertaining as well.

The Blunt Bean Counter describes how to gift money to grandchildren through RESPs, TFSAs, RRSPs, and your will.