Don’t Invest in Bonds? Visiting the Strong Reasons Against

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At one point in time, bonds were a chief investment and were even a necessity to have in one’s own portfolio.

But it feels that those times have changed, and we hear less about them.

Instead, we constantly hear about the glories of index funds and ETFs that will track a market’s 12% return for some time.

So what are these reasons that more and more investors are shying away from bonds, and do they hold up?

I want to review these negatives to determine whether bonds should be avoided and the money invested elsewhere.

Join me in an analysis of bonds.

Why aren’t investors buying bonds?

I’ve seen among a bit of the research I have done a commonality among some of why investors aren’t investing or recommending people to buy bonds.

That main argument was the bond yields, in that they have been extremely low.

Low Bond Yields:

Let’s look at the current state of the bond market and what is currently being offered on government-issued bonds.

Reflecting the date a the time of this writing, March 9, 2022, here are what the marketable bond average yields are:

Length:Yield:
1 – 3 years1.41%
3 – 5 years1.58%
5 – 10 years1.74%
10 years +2.12%

By viewing this table, we can establish the belief that the returns aren’t very ideal through some initial thoughts. In fact, there is one high-interest savings account currently offering a higher annual savings rate, that being the Wyth HISA (not a sponsor btw).

Many of us might also attribute that these earnings annually won’t even beat out inflation, which is not a good sign for those looking to build their wealth through a diversified portfolio.

But I will argue that to better understand whether these current rates are high, we need to compare them to the average rates from years ago.

The Performance of 10-Year Canadian Government Bonds for 35 years

 At first glance, you would suggest that the interest rate was very high in 1985 (where it nearly was 12.50%) for 10-year bonds. In which, you would be correct.

But understand that the interest rates at that time were not attractive.

During the 1970s, the U.S. was going through a high level of inflation, and as you will be able to see below, Canada did the same.

<a href=’https://www.macrotrends.net/countries/CAN/canada/inflation-rate-cpi’>Source</a>

The main reason for the huge shock of inflation? Well, it was the increase in the money supply that was the biggest reason, while the ’70s was also couped with high amounts of unemployment and even surging gas prices (something we’re seeing currently).

If you’re not familiar with how inflation and monetary supply work, I’ll attempt to give a brief 101, and by no means am I a perfect economist or an economist at all.

For a moment, let’s pretend we have a perfect economy; supply is equal to demand. No tipping of any scale here.

Then, suddenly, the government decides to increase the money supply or the amount of money circulating within an economy.

With a higher amount of money circulating in the economy, this ideally means that people will have more money and can therefore spend more money.

So with people wanting to spend more money, goods are now wanted at an increased demand. And if goods are wanted at an increased demand, companies can charge a higher price. This would also mean that companies purchasing goods from other companies will need to set higher prices as prices from suppliers are increasing.

And since inflation is the price of goods increasing over time, we now will see an effect of inflation.

That’s how economics works in a very tiny window and with a non-economic background.

But how does inflation in any way affect the interest rates?

Well, a 102 of economics tells us still I’m not an economist, but this is my understanding.

The interest rate has an inverse relationship with inflation. Inflation increases as interest rates decrease because it is easier and cheaper to borrow money (and inflation decreases when with rising rates of interest).

So, if inflation was high in the 1970s, governments would increase the interest rate to incentivize people to save more, hopefully lowering demand and increasing supply.

Hence why interest rates were high during the ’80s.

How Inflation Affects the Returns of Bonds

To compare it to today’s rates, we need to account for the inflation during the ’80s to understand what the real rate of return was for that period.

As well, I will do a table that reflects the yields of 10-year bonds in 5 year intervals that will be subtracted by inflation below:

Year:Bond’s Average Yield Subtracted by Inflation:
19858.11%
19902.208%
19955.564%
20003.046%
20052.449%
20101.198%
20150.054%
2020-0.2236%
2022-2.98%

Side note: I used January 2022’s inflation rate, which can be found here.

So, what does this all tell me and you about bonds?

If it wasn’t obvious enough in the average yields throughout the years, the average yield for 10-year bonds has been down since 1985. For bond investors, I’m sure this isn’t very ideal.

Now when you do the math, you see that returns haven’t been very ideal for investors unless they could lock in an excellent fixed rate for some time.

But newer investors over the years weren’t able to lock into such lovely rates as the 80s provided, despite the inflation.

Remember, these are the Government of Canada bonds. These aren’t high yield bonds, junk bonds, municipal bonds, etc.

Rates certainly will be higher for other bonds with lower credit ratings, but I did need a benchmark to compare some of this data to.

I decided to select Government of Canada bonds because:

  • A) they have an AAA quality grade meaning we know they will not default and are a reliable investment to measure
  • B) of 10-year government bonds, they would likely pay the highest (maybe besides 20-year bonds) and as well, might be a more realistic investment for investors to select

So, in this scenario, throughout the years, bonds have had lower yields, even adjusted with inflation, making this a good criticism in my eye of this type of investment.

The volatility of the Bond Market

I had initially wanted to look up the pricing of the Government of Canada bonds to look through the pricing over the years that would hopefully show us a straightforward argument that they are volatile.

Unfortunately, I’ve had no such luck with finding the previous pricing.

I suppose it might be difficult to accumulate this data as well, volatility of bonds varies mainly from the interest rates being offered from the bond itself compared to the market as a whole.

If we think about it in theory, if one is only earning 2.5% of interest on a 5-year bond, when others could be earning 3%, that would primarily affect prices. Pricing would be affected because investors would pay less to earn less interest since there are better returns in the market.

So, due to not quickly finding fluctuation in pricing over a long-term period, I’ll instead use a model that will help us analyze the effect of bond volatility.

And in no ways do I take credit for the model itself, but using the analysis from Nuveen.com to add to this section.

The Model

Their argument of price volatility stems from two points.

  1. Interest rates affect pricing
  2. Length of maturity affecting pricing

They used a model of duration as it can estimate how much the price of a bond will change in response to the changing interest rates. While I won’t go full-blown into their analysis, I recommend you check it out for yourself.

But their argument is if you can multiply the modified duration from the change in interest rates, you can approximate the percentage of change in the bond’s price.

A general rule of bonds is that those that will pay interest before maturity will have a duration less than maturity, and the larger the coupon, the shorter the duration. The cause of this would be that investors will take less time to earn back the present value of their investment, in which they can look elsewhere for other investments if desired.

Here’s a graph that they were able to calculate:

The graph tells us that investors in these bonds are not holding out until maturity. Now, this could be a result of numerous things:

  • People could be selling bonds and looking for investments elsewhere
  • These bonds could be callable
  • Investors are only worried about earning their present value investment back.
  • Declining interest rates allow investors to earn an excellent return.

Yet either way, there is a difference in maturity and duration, which reflects the volatility of bond prices.

Is the Argument Good?

I don’t think it’s a terrible argument. Bonds are certainly going to fluctuate in price, and as a result, people will lose the chance to earn a better return than what they will at maturity or a current date.

But what about the average investor just looking to invest in bonds? One who does not care about the fluctuation in prices but only fixed income?

For that reason, to me, it wouldn’t really matter for these types of investors. Whether you can find a better-fixed income investment is a different article for a different day. Today, this is an alright argument based on that situation alone.

Sole investors in bonds would definitely consider this an intense weakness of bonds.

The Stock Market Has Outperformed the Bond Market

One of the main arguments that I have heard is that the stock market has outperformed the bond market, and why people stay away from bonds is because of this.

I don’t find the argument blasphemous. Yet, I want to look at a couple different measures, which I will briefly explain below.

First, we’ll look at the S&P/TSX’s returns over the past 35 years since we can compare them with the returns of the Government of Canada’s 10-year bond yields and the inflation over the same period.

Second, we’ll take a glance at a popular blue-chip stock, being Coca-Cola, that many investors would have held over the same period.

Next, we’ll look at a current figure, where I’ll compare the amount of fixed-income provided from an ETF versus a bond.

Performance of Bonds versus the S&P/TSX

Sources used: S&P/TSX Composite index (^GSPTSE) Charts, Data & News – Yahoo Finance and S&P/TSX Composite Index (Canada) Yearly Stock Returns (1stock1.com)

Here we have the yearly returns for 5-year intervals since 1985.

To reflect how the index has grown since 1985, here’s another chart.

The first one might highlight that the stock market hasn’t earned very lucrative returns, but over the last 50 years, the index has yielded an average return of 9.6%.

Either way, investors during these 50 years would have earned a very lucrative amount on their invested amounts.

Now let’s look at the real yearly rate of return so we can compare it with what bonds were offering each time.

Vs.

What does this tell all of us?

There is one point we should consider. The bond yields slated through this data would be offered at a fixed rate. Meaning if a bond in 1985 was offering 8% yields adjusted for inflation, that is the amount investors would earn for its maturity.

It’s hard to look at the yearly return because of these fixed-term yields, yet we can look at what bonds and this index offer investors each year.

Here’s a table of the exact amounts:

Year:Real Rate of Return for Bonds:Real Rate of Return for S&P/TSX Index:
19858.11%3.32%
19902.208%-22.74%
19955.564%9.71%
20003.046%3.46%
20052.449%19.70%
20101.198%12.67%
20150.054%-12.22%
2020-0.2236%1.45%
2022-2.98%-3.97%

This tells us that bonds clearly haven’t offered much loss during all periods, except for this year, which has acted as an inflation-protected investment. Yet, the significant returns from the S&P/TSX index would indeed have outperformed the returns investors would have earned from these bonds.

Also, consider that Canadian Government Bonds over 10 years would have only provided an average yearly return of 6.8% versus the S&P/TSX’s return of 9.6% for the same period.

So, I think it’s safe to state that the index outperformed bonds, given this sample size but if I were to analyze this more, I would also consider bond index funds or other bond funds.

Performance of Bonds versus Coca-Cola Shares

Now some data about the Coca-Cola stock.

(sources used: KO: Coca Cola Company Yearly Stock Returns (1stock1.com) and The Coca-Cola Company (KO) Stock Price, News, Quote & History – Yahoo Finance)

And compared with bonds:

Now a table of the differences to follow:

Year:Real Rate of Return for Bonds:Real Rate of Return for Coca Cola Stock:
19858.11%3.32%
19902.208%-22.74%
19955.564%9.71%
20003.046%3.46%
20052.449%19.70%
20101.198%12.67%
20150.054%-12.22%
2020-0.2236%1.45%
2022-2.98%-3.97%

This type of data tells us a similar story as the entry above. Coca-Cola’s stock has outperformed bonds over the long run, but those bonds were the better inflation-protected security through each individual year.

It’s funny, though, Coca Cola I didn’t factor in the distribution (or dividends) that the company would have paid out to shareholders through these years. This would also help them outperform 10-year bonds over the selected periods.

But speaking of distributions….

Performance of Bonds versus XEI.TO

Let’s look at one more situation because we have come way too far not to, right?

Well, in the previous two situations, I’ve looked at the performance of an index versus a share. But, how about looking at a hypothetical performance of a dividend?

Bonds are notoriously known as fixed-income investments, and dividend investing is becoming a fixed-income investment strategy.

Why not compare the two?

XEI.TO is an ETF created by Blackrock focused on returns from dividends. Every month the dividend is paid out, and it’s designed to have a long-term holding in one’s portfolio for this reason.

The monthly amount paid is $0.08. Initially, you’ll come to think that amount being offered here isn’t very large, which I would agree with. Especially the case if we were to immediately compare it to bonds.

Now, let’s switch the narrative a little bit.

Calculation

Here we have a Canadian Government bond that we’ll assume is a 10-year bond. To purchase the bond today would cost $103.89.

As of today’s date of this writing, March 12, 2022, to purchase a share of the XEI.TO ETF, it costs $27.93.

The semi-annual interest rate for the bond is 1.680%. For the year, this means that the bond would pay out a total of $3.36 in interest.

Let’s say that to match the bond price, one purchased 4 shares of XEI.TO, which costs $111.72.

We know that they pay out a total dividend of $0.08 every month, so by 12, we’ll say that’s $0.96 yearly.

If we multiply that by 4 shares, that equals $3.84, slightly better.

Instead, let’s say the bond cost $1,038.90 and paid out the same interest rate.

To match the bond price, 37 shares of the XEI.TO ETF will be purchased, totaling $1,033.41.

Here’s how much distributions would be paid out annually with the same method of calculations above.

Not much of a difference, is there? Now, with the ETF, it could earn a few dollars more through appreciation. However, owning the ETF would have a management fee and the potential to lose money through holding it at the same time.

I do encourage you to take your favourite dividend stock or ETF and compare it to a bond, even the one I used as an example.

However, I feel that this part of the argument holds up, but not largely. Bonds pay a very similar rate while no management fees must be paid.

Even simultaneously, bonds could increase in value earning the investor money if they decide to sell.

Do the Arguments Hold Up?

I think they do hold up.

Bonds offer lower yields now than ever, as we have seen through the example of the 10 year Government of Canada bond yield.

At the same time, bonds can be very volatile and might be a concern for those investing a majority of the funds into bonds. Yet, I will still argue that those looking to hold bonds until maturity for the fixed income wouldn’t need to worry as much.

Additionally, the stock market has outperformed bonds, while bonds will probably at times keep up with distributions versus dividend-focused stocks or ETFs.

Yet, this is just my own analysis and opinion, and I recommend you do your own research and form your own opinion. If you happen to look at other bonds, such as municipal bonds or corporate bonds, let me know.

I’ve also included the links for where I found the arguments so you can view them and listen to their side. And with me providing the links, I’m not trying to flame anyone for having a wrong opinion. Instead, I just want to reference the sources and for others to hear their views, just as they will read mine.

So, do you think these arguments hold up and do you own bonds? Let me know via email or on social media.

Don’t forget to check out my original post on bonds and other posts on personal finance.