October 08, 2010
Moshe A. Milevsky
At first thought, there is nothing quite as comforting as the safety of government bonds. You’re guaranteed to get your money back when they mature, the coupons are paid on a regular basis, the risk of default is miniscule and if you are in a pinch, you can always sell them for cash.
And yet, I really don’t like bonds and don’t own any. Why not? Here are six reasons and if any my arguments resonate, you should consider lightening up on your bond holdings as well.
1. Investing in yourself
Many people think that the largest investment they have is their retirement savings plan, or perhaps a house, or cottage. But the biggest investment is really you. The income, wages and salary you will earn over the next 10, 20 or 30 years of working life can be viewed as coupons. You and your earning capacity are the bond. Or, think of yourself as a gold mine or oil well with decades of remaining reserves.
The safer or more secure your job, the bigger the bond quotient. In other words, at the age of 42 I already own tons of bonds, they just aren’t traded.
2. Avoiding double jeopardy
Almost a decade ago, I did some research on the best way to buy a home and in particular whether it was better to get a long term or short term mortgage. After a lot of number crunching, the clear winner was a floating rate, short term mortgage. It could save thousands of dollars on a typical mortgage.
I put my money where my research mouth is and use a floating rate line of credit instead of a fixed rate, long term mortgage to finance the purchase of my home. That leaves me exposed to the risk that rates will rise sharply and my interest costs will increase. But I am willing to live with the risk.
My main point is that I am not willing to expose my investments, which are assets, to that same risk as the mortgage on my house, which is a liability. Here’s why: If I own bonds and interest rates go up, the value of the bonds go down. But I am already exposed to that risk with my line of credit. Why go for double jeopardy?
3. The tax bite
The interest on a bond is taxed at your full marginal tax rate. In Ontario that rate can get as high as 47 per cent if you are in the top bracket which kicks in at incomes above $127,000 per year. So, basically half the income from the bond is being taken away. Some countries exempt government bond coupons from full or partial taxation; not so in Canada. So, this is another reason why I avoid this type of income. Some would argue that you should keep bonds in your RRSP, but I disagree. See below. I prefer unrealized capital gains, or dividends. They get preferential tax treatment.
4. Long run vs. short run
A critical question when saving is: when do you need the money back? Is it a rainy day fund? A down payment for a house or cottage? For retirement? Emergency cash reserves should be sitting in short term things like money market funds and savings accounts and a change in interest rates shouldn’t have a meaningful impact on its value.
This is why my retirement money is all in a portfolio of global stocks. For the truly long-run, I want to own a piece of the global economy because I believe the eventual growth and profitability of these companies will return far more than a fixed-interest bond.
5. Inflation is a worry
Most bonds and bond funds pay coupons in today’s dollars, which means you are being repaid in dollars that depreciate over time. For example, suppose you have a five-year bond that pays $100 a year. The $100 in year five has less buying power than the $100 in year one.
I would also argue that a bond isn’t really giving your money back at maturity. It is only giving you yesterday’s money back.
Inflation-linked bonds do offer protection but the measure of inflation is defined by the same government that has to make the payments. Who’s going to get the better deal? That conflict of interest worries me.
6. Defined benefit pensions
My final reason for not owning bonds is a sore topic for many Canadians. I am fortunate enough to have a defined benefit pension. This sort of plan guarantees a monthly payment and is not to be confused with a defined contribution plan which has no guarantees and where you are at mercy of the market and even scarier, possibly professional investment managers.
My pension promises me payments for the rest of my life – just like coupons on a bond. So, there it is again, I already have some bonds. Why do I need any more?
None of these six reasons include any guesses about where interest rates are headed, and what the Bank of Canada plans on doing over the next few months. Rather, my arguments are about taking a very close look at your personal balance sheet and making sure that your decisions account for all the moving parts in your financial life. So, if any of the above reasons resonate, then perhaps its time to lighten up on the bonds.
Moshe A. Milevsky is a professor at York University’s Schulich School of Business. His latest book is Pensionize Your Nest Egg.