More on the Estimated Return of Bonds

In an earlier article, (part of my Chapter 2 notes on "Investor's Manifesto" by Bernstein) I looked at the interest rate of investment-grade corporate bonds, their historical default rate, and estimated inflation rate, and couldn't figure out why anyone was buying corporate bonds. However, I wasn't very confident in my analysis -- I thought there was a good chance my analysis was wrong. I've found an article that makes me a little more confident that my analysis is correct.

To summarize: Corporate bonds you can buy today are paying around 3.27% interest. You can estimate inflation to be between 2 and 4% in the future. And you can estimate your bond default rate to be between 2 and 4%. Even with the optimistic version of both, you're looking at negative returns. And with the pessimistic versions of those numbers, you're looking at losing almost 5% of your investment annually.

Now, let's assume my analysis is correct. People are buying corporate bonds at these rates. (Because companies need bonds -- need people to loan them money -- and if people weren't buying, companies would have to increase their rates.) Why are people doing this?

  1. Conventional wisdom is that you should "invest your age" in bonds. If you're 30, 30% of your assets should be in bonds. If you're 60, 60% of your assets should be in bonds. This is because bonds have a lower risk and lower return than stocks. Looked at in isolation, bonds are a bad investment. But if stocks end up tanking by 80%, as they did in the Great Depression, losing 5% on your bonds might seem a good result.
  2. Speculation. Although interest rates are very low, it's still possible for them to go lower, which would increase the value of bonds purchased today.
  3. Bonds in recent history did very well. Remember, if you bought a bond when interest rates were 10%, and sold it when interest rates dropped to 5%, your investment would double. Interest rates have gone to historic lows, so people who already owned bonds have done spectacularly. This is why you should not judge a possible investment by historical returns. People who buy bonds today will not get these same returns.

Reason #1 makes sense, but I tentatively think it's a bad idea. If you're going to accept bad returns for safety, use Treasury bonds, or a money-market account, or (if your assets are under the limit) an FDIC-insured saving account.

Reason #2 strikes me as pure insanity. Some people are probably both intelligent enough and skilled enough and risk-tolerant enough to pull this off, but I know I'm not one of them.

Reason #3 is based on ignorance of the fundamental principals of investing.

All of this makes me think that corporate bonds should not be a part of a prudent portfolio at this time.