Investment That Protects You From Yourself: Bonds

Rick Ferri, founder of Portfolio Solutions, an investment advisory firm with $1.2 billion in assets, isn’t buying the bonds-suck meme that has recently become fresh meat as both Pimco’s Bill Gross and Berkshire Hathaway’s (BRK.B) Warren Buffett went out of their way in the past week to diss the asset class.

In a post titled A Reason to Own Bonds, Ferri makes a refreshing case for why bonds remain a vital piece of an investment strategy. Don’t worry, this isn’t a tired dissertation on the need for diversification. Nor is Ferri trying to put lipstick on a pig. He’s well aware that low yields and negative real returns aren’t exactly wealth enhancing. “Finding someone who likes bonds today is like finding someone who enjoys strolling through poison ivy. I don’t enjoy poison ivy either, nor do I like the low yield of bonds. Yet, I do believe there is a good reason for most people to own bonds.”

So what’s his case for bonds? Quite simply, they keep you from investing (too much) in stocks. Ferri’s hitting on the very relativity trap that is coursing through the market. It’s been obvious for some time that bonds are running on fumes after an epic three-decade run. The problem is that if you extrapolate that stocks are therefore a better investment, you’re likely to shift out of bonds and into stocks right about now. As Ferri points out, that’s a bit of a risky move given that the stock market is at an all-time high. Moreover, Ferri makes the point that if you’re overloaded on stocks and the market corrects, behavioral finance has taught us you’re far more likely to sell to escape the pain. With less invested in stocks -- and more in bonds -- it can become far easier to live through a correction without bailing, which tends to work out a helluva lot better than ill-timed selling.,/p>

So while Ferri’s no bond lover, he does appreciate their value: “A bond allocation helps protect a portfolio from its owner.”

The paltry yield on bonds has sent increasing numbers of investors looking for dividend-paying stocks. That interest has pushed up valuations sharply. Johnson & Johnson (JNJ), dividend yield 3.1%, now has a PE ratio of 24. General Electric (GE), dividend yield of 3.3%, now trades at a PE ratio of 18. And Intel (INTC), which has yet to successfully shift from PC chips to mobile computing, dividend yield 3.7%, has a PE ratio of 12, after trading with a multiple in single digits for part of last year. The income is nice but in a market correction, these stocks could all fall sharply.

For all his hand wringing, Bill Gross has managed to navigate the one-year-old Pimco Total Return bond ETF (BOND) to a return that in bond-terms kills the return of the iShares Core Total Return ETF (AGG) which tracks the benchmark bond index.

BOND Total Return Price Chart

BOND Total Return Price data by YCharts

If Pimco Total Returns’ 4.52 year duration is too long for your taste (duration measures a portfolio’s interest rate sensitivity; if interest rates were to rise one percentage point a portfolio with a 4.52 duration would see its price fall 4.52 percent.) the $12 billion Vanguard Short-Term Bond ETF (BSV) has a 2.7 year duration. The tradeoff is a 1.4% yield compared to 2.1% for the Pimco portfolio. And hey, while it pays bupkes, don’t forget about cash. It’s not going to budge when the market makes a move down, and cash gives you instant liquidity to buy into stocks at lower valuations.

Carla Fried, a senior contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine. She can be reached at editor@ycharts.com.

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