If you have been around the personal finance and investing space for long, you have likely heard the phrase “Debt is a negative bond”. Today we're going to talk about what that means and its implications on your financial life and portfolio construction.
The basic concept is pretty easy to understand. Let's assume you have a $200K investment in a stock index fund and a $100K student loan. Your net worth is $100K. What is your asset allocation? Many people would say “100% stock”, but that is not technically true. In reality, you are 200% stock. This is the classic argument used against fans of 100% stock portfolios. If 100% stocks and 0% bonds is best, why not 120% stock or 200% stock? Where a bond provides “ballast” to a portfolio, softening and even reducing the blows of stock market downturns, debt does just the opposite. That leverage magnifies returns, both positively and negatively. If you have $200K in stock and $100K in debt and the market drops 50%, your net worth has gone from $100K to $0K. You've been wiped out. Likewise, if the market doubles, your return is not 100%, but 200% as your net worth has gone from $100K to $300K.
From a return perspective, paying down debt is just as good (and usually better) than investing in bonds. It does not make a lot of logical sense to invest in bonds paying 1-2% while carrying a 5% student loan, much less a 15% credit card. Paying off that credit card is probably the best investment available to you, and paying off that student loan certainly beats buying a bond fund, CD, or similar investment. If you have a 5% non-deductible debt, paying it off provides you precisely a 5% after-tax, risk-free return. That's actually pretty good.
Why Hold Bonds When You Have Debt?
So why does anyone with debt ever use bonds? Well, there are a few reasons.
# 1 They Don't Know
There are some people out there who don't know that debt = a negative bond. Ignorance isn't always bliss. If you don't know, maybe you build what seems like a reasonable stock/bond portfolio and ignore that debt as “something else.”
# 2 Different Pots of Money
This is the main reason I still invested in bonds back when I had debt. For every financial goal, I have a different asset allocation. For example, my retirement portfolio is 60/20/20 stocks/bonds/real estate. My kids' college portfolios and UTMAs are 100% stock. Their retirement accounts are 90/10. My short-term savings is 100% cash etc. In that respect, my “pay off the house money” was 100% negative bonds most of the time, although there was a year or two long term readers will remember when we had both the mortgage and some stock index funds designated toward that goal. Another reasonable person may choose to look at all of their money (retirement money, college money, short-term savings money, etc.) as one big pot and have one big overall asset allocation for that. If you do that, you might not carry any bonds at all until you've paid off all your debt. Just a matter of perspective.
# 3 Can't Tolerate Volatility
One of the reasons that people put bonds in their portfolio is to act as a diversifier for stocks. Often, when stocks go down, bonds, particularly very safe bonds like treasuries, go up in value, offsetting your loss. This effect, combined with the fact that you have less of the portfolio in stocks, provides ballast to the portfolio, moderates its returns, and helps you to avoid panicking and selling low. It might sound dumb to sell low when I write it and you read it, but every time there is a market downturn I see doctors panicking and selling low, even relatively financially literate ones. Long treasury bonds perform this function best, but come with their own risks given their very long duration–they can have big losses in times of rising interest rates and are particularly susceptible to inflation, so most people stick with short to medium term bonds.
# 4 Bonds Provide Income
Some people have, at least in the past, bought bonds for their income. Andrew Mellon famously said, “Gentlemen prefer bonds.” Many retirees like having the income from bonds and dividends to help them spend their money (obviously they could “declare their own dividend” any time they like by selling shares). Lots of people like “multiple streams of income” or “passive income” even during their working years to pay some of their expenses. This used to be a pretty good reason to have bonds, but it's probably not a great use anymore. I mean, when I started my investing career between the Tech Stock Meltdown of 2000-2002 and the Global Financial Crisis of 2008, I could get as much as 5.25% on cash in a money market fund and bonds had similar or higher yields. But we haven't seen those kinds of yields in years. So this really isn't a great reason to buy bonds these days. Paying off (but not necessarily just paying down) debt also improves your cash flow, by the way.
# 5 Something To Sell When Stocks are Down
Jonathan Clements penned an article recently that this may be the only reason bonds are currently worth holding at these low interest rates. This matters a lot more to a retiree than someone still working with an emergency fund and an appropriate insurance plan. Basically, if you need cash in a stock downturn, you can simply sell the bonds.
# 6 There's a Chance Bonds Outperform Stocks
Finally, there is always the possibility that bonds can outperform stocks. While expected returns on stocks are higher, especially over very long periods of time, you don't always get expected returns. In fact, there have been three lengthy periods of time (10-15 years) in the last 100 years (1930s, 1970s, 2000s) when bonds outperformed stocks. There is no rule saying those periods could not have been even longer or even last your entire investment career. Owning some bonds in your portfolio hedges against that possibility.
Know why YOU are investing in bonds and remember that debt is simply a negative bond and paying it down is often your best fixed income investment and sometimes your best investment of any type.
What do you think? Do you carry debt while investing in bonds? Why or why not? Do you view your debt as a negative bond? Comment below!