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?
- 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.
- 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.
- 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.