Bonds are the Rodney Dangerfield of investments. They get no respect, and apparently they’re also Mr. Burns’s son.
It’s pretty obvious why many investors want nothing to do with bonds in the year 2016 (WHERE ARE THE FLYING CARS? HUH?). The interest rate offered on high-quality bonds is less exciting than a date with your sister. GIC yields are even worse. And even though the TSX finished 2015 in negative territory, stock pickers are still comforted by the fact that it’s easy to build a dividend portfolio that yields more than anything but the riskiest bond fund. Add in dividend growth and solid results from U.S. stocks when converted back to local currency, and it probably wasn’t a bad year for the folks who insist on being 100% into stocks.
Related: The surprising reason why you should own bonds. OOOH TEASE
An argument I often hear from folks who are fully invested in stocks goes something like this. I don’t need no stinking bonds, they say, because I’ll be collecting CPP when I retire. That, combined with any pensions I might have, are the perfect bond substitute.
There are lots of similarities between bonds and CPP. Both offer predictable payments. Both aren’t known for growing the distributions they pay much, if at all. And both are far more stable than stocks. They’re even more stable than a well diversified portfolio of dividend growth stocks. Even if a company goes bankrupt, usually some remnant of the pension remains.
These points are true. But the folks who think CPP is a bond substitute are missing a couple of important points.
What about the capital?
The big issue with pensions and CPP is you can’t access the cash. With certain pensions you might be able to get a lump sum payment, but it’s generally not a good idea. The whole point of having a pension is you sit back, relax, and money falls out of the sky each month.
Meanwhile, if you buy a whole portfolio of bonds, GICs, or whatever fixed-income substitute you want to use, you have access to that cash at any time. You might have to pay a bit of a penalty to get out, but it shouldn’t take much longer than a day to get your money. All of it.
The other thing about pensions is at the end of the day, you’re getting interest plus some of your money back. If you live longer than expected, it’s okay. Your buddy Tim probably keeled over before he was expected. Thank him for his share when you visit his grave.
Thus, I think the whole comparison is off. Pensions aren’t a bond substitute. They’re annuity substitutes. There are a lot of similarities between annuities and bonds, but they’re not the same products. Not by a long shot.
The real reason bonds are important
Most investors gloss over the real reason why bonds are a big deal. They level out returns during periods of uncertainty.
I’ve argued before for a system that increases an investor’s bond allocation to between 80 and 100% between the ages of 60 and 65, especially if the market is hitting new highs. The argument is that you want to lock in gains at that point and ensure there’s going to be enough left over for spoiling the grandkids and buying pants that go up to your armpits. Once you hit retirement age, you start to increase the risk tolerance again, eventually ending up at a more traditional bond/stock mix.
The whole reason why bonds are important to a portfolio is they do well during periods when stock markets don’t. As a perfect example, take a look at bond returns compared to TSX Composite returns for the year of 2015.
The total return on that bond ETF would have approached 4%. That ain’t bad when compared to the TSX Composite. A 50/50 split between bonds and stocks wouldn’t have lost much more than 5% after considering dividends.
I’m continuing to buy Canadian stocks at these levels because I can find good value out there. I’m even selling off some bonds and preferred shares to do so. Bonds also serve as a terrific capital base for folks who are fully invested.
Back in 2014, I couldn’t find much to invest in. So I threw money into one-year GICs and promo accounts from a certain orange-colored bank. I averaged around a 2% return, which ain’t very sexy.
But I also protected my capital. And now that I’m finding value in the Canadian market, I’m putting it to work again. I’m buying the stocks I picked for the stock picking contest, plus some other, more conservative choices. I have this capital available because I kept 20% of my money in fixed income when times were good. Somebody 100% invested in stocks back in 2014 has very little capital available to take advantage of a downturn.
If you allocate CPP as your bond substitute, you won’t have that money available to invest when there are opportunities out there. You’re stuck taking all the risk of the stock market. If you’re old enough to be collecting CPP in the first place, that’s a bad idea.
Look at CPP as an annuity, not as bonds. If you do, you’ll likely see the pros of having a healthy bond component when you retire. Remember, retirement isn’t about ending up with the most cash. It’s about protecting the cash you already have.