Why investing in bonds is a big mistake

TL;DR: Financial advisors everywhere suggest including a mix of bonds in your investment portfolio. This advice is too generic to be useful. I don’t own any bonds, because they lack both upside potential and inflation protection. If I want yield, I find it through other investment vehicles (like real estate) that offer higher yields, upside potential, inflation protection, and favorable tax treatment. Bonds make more sense for investors like pension funds, but aren’t a great fit for someone interested in reaching Ramen Retirement and maximizing long term wealth creation.

Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.

– Ronald Reagan

Investment advisors all parrot the same advice that bonds should be a part of anyone’s balanced investment portfolio. I disagree. While bonds have their place in the investment world, they’re not something I touch given my investment goals (long term generational wealth creation) and time horizon (forever). While they promise guaranteed returns that are almost entirely passive, the reality is not quite so rosy. Below are a few of the reasons to stay away:

Lower long term returns

The biggest reason, for me, to stay away from bonds is the lower returns. From 1926–2015 the S&P 500 Stock index returned 10.02% annually while bonds (Citigroup high grade index) returned 6.08% annually (source). Hey, that’s only a 4% difference, right? That’s not too bad, is it? No, not bad, fucking terrible! Compounding returns is not a concept our monkey brains can grasp well, so let me put it in terms you will understand. Over a 30 year period, that 4% difference amounts to a 3X difference in your ending value. Starting with one dollar, it would have grown to ~$5.74 invested in bonds… or $17.45 invested in stocks. If we play this out over 90 years, your $1 bond would have grown to a nice $189.46, but if you invested in stocks (the benefactors of American ingenuity and progress), you would have $5,313.02 – roughly 28X more! Boom – mind blown!

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Unfavorable tax treatment

On top of the fact that bonds generally offer lower returns than equity, they also receive less favorable tax treatment. Interest income is taxed the same as your ordinary income. If you’re a high income earner, this means you could be paying more than 50% of your interest income in taxes. Contrast this with the various tax benefits of equity ownership:

  • Qualified dividends generally receive favorable tax treatment from the Federal government, topping out at a 20% marginal tax rate
  • Capital gains receive this same favorable tax treatment from the Federal government, topping out at 20%
  • Real estate equity generates profits that are taxed as ordinary income, but the ability to write off depreciation of a property helps shield that income in a material way, bringing the marginal tax rate (particularly in the early years) way down!

I don’t need the ‘stability’ a bond offers

Despite the incredible difference in returns highlighted above, some financial advisors still suggest bonds offer diversification, helping to buffer your loses in times of market turmoil. While this is true, the reality is that I don’t need that ‘stability’. If you don’t plan to be selling assets (which I don’t), then a market downturn doesn’t really affect you. That sort of stability is a lot more important for pension funds who might need to sell assets at any time to meet their pension needs / withdrawals.

Vulnerable to inflation

One of the biggest risk to bonds is inflation. Sure 6% might sound like a good return in today’s low interest rate, low inflation environment, but if you go back to the 70’s and early 80’s, a 6% yield would be losing purchasing power every year with inflation hovering in double digits. It’s hard to imagine for the generations born after 1980, but high inflation is a real thing that can destroy the purchasing power of your bond yields. Not even US Treasury Inflation Protected Securities (TIPS) will help you, because the government has rigged the system – they are the ones that define the ‘level of inflation’, and for anyone living in the real world, the numbers they post just don’t match experience.

Historical_Annual_U.S._Inflation

Source

No guarantees

While bonds talk about guaranteed returns, the reality is that they are only as good as the underlying asset or borrower. Bonds can default. Unless you’re buying government treasuries, there’s still a risk of capital loss. While they might be lower on the capital stack, they’re not immune from adverse events as the Financial Crisis taught us.

You can still lose principal

Yes, if you hold a bond to maturity you will get back your ‘principal’ assuming they don’t default… but if you want to sell that bond anytime before then, you could have a major capital loss just like any other asset you can buy or sell. If interest rates go up, the price of bonds go down. In this low interest rate environment, a major move up in rates could crush the value of your bonds, thereby locking you in to mediocre returns for a long time, or forcing you to sell at a loss.

Not always passive

If one of your bonds defaults, that ‘passive investment’ suddenly becomes pretty active. You’ll be left cleaning up a mess left behind from the equity holders. This is not something you’ll deal with if you own a bond ETF (thought you could still experience the losses), but if you’re playing around with real estate notes or some other form of personal loans, you could be left holding the bag

So hopefully you can see all the drawbacks of bonds. As mentioned, some investors want bonds in their portfolio – particularly institutions that need a high degree of confidence in their nominal dollar returns like pension funds and insurance companies. Those types of investors often talk about Sharpe ratios and risk-adjusted returns, which are useful concepts in the abstract but miss the point for me as an individual. Yes, it’s true that bonds might outperform in periods of market decline – historically there is some evidence for that –  but for the investor interested in maximizing long term returns or reaching Ramen Retirement, there are better ways to do it. You can get higher yields, tax advantages and inflation protection from equity real estate investments. If you want passive long term growth, go for a low fee total market equity index fund (See Vanguard Total Stock Market ETF: VTI, or for Ex-US: VEU) – it comes with a nice dividend, growth potential, and inflation protection. Not as high yielding as some real estate investments, but also worth having as part of a diversified investment portfolio.

But as with everything, the best investment really depends on your goals. The definition of Ramen Retirement is about having income that will:

  • Be stable and predictable
  • Be insulated from market fluctuations
  • Be inflation protected
  • Have potential for growth

Bonds don’t pass the test, and therefore don’t make it into my portfolio.

As always – enjoy the journey!

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