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!
Thanks for the reminder that carrying debt is effectively leveraging all the assets on your personal balance sheet. After following your posts on real estate syndicate investing I am (very slowly) learning about the “capital stack” and how it’s possible to choose where you want to invest within the stack (e.g. equity, preferred equity, debt, etc.). How do you think about where you are in the real estate capital stack in terms of your effective asset allocation? For instance, if you have 10% of your assets in real estate syndicates and you are in the equity portion of the capital stack that could effectively mean you have a greater than 10% allocation depending on how leveraged the deal is. How do you think about this in your investment plan? Am I over-complicating it?
I don’t include the leverage I don’t control. Just like I don’t count in any Ford bonds when I buy Ford Stock via an index fund, I don’t count in the debt of a REIT or a private real estate fund when I invest. So yes, I think you’re overcomplicating it.
Not sure you are over complicating it, but you might find difficulty in knowing how much leverage there may be, depending in the nature of the investment. It is certainly wise to account for leverage in assessing the riskiness of a deal and of your overall portfolio. For individual deals, you can explicitly or simply mentally account for higher volatility of more highly leveraged bets.
For your portfolio overall, there is not a simple relationship between the volatility of a componenet and overall volatility. That would depend on the covariances, which you probably do not know.
Debt provides leverage. Debt also provides liquidity.
This is a topic I’ve been thinking about recently. I’m going to need to increase my bond allocation in the near future but decided to hold off on buying bonds in taxable and instead pay down the mortgage. Never thought this would come up given my low mortgage rate, but it is what it is given current bond yields.
I have 15% bonds in my asset allocation and o also have a lot of student debt that I am still paying off aggressively.
The reason in my mind is that I view it as a delegate “pot” and also because I feel that the actual bonds dampen the volatility not only from having the stocks but from the debt itself as you point out in your example.
My full plan w more info it here: https://prudentplasticsurgeon.com/still-need-a-written-personal-financial-plan-hereuse-mine/
So, here’s a conundrum:
If we take stocks to be negative bonds, how should that factor into investment/savings rate?
The advice Jim gives is that early-career physicians should aggressively pay down their student loans. Yet, I think he would also agree that an early career physician should put very little in bonds to start (see his “you have to take risk” article).
So, what are we meant to do then? Invest wholly in stocks and make minimum payments on student loans/mortgages? Or pay off the debt knowing that we are, in effect, overweighting our investment strategy to bond-equivalents early in our career? Is it all just risk-tolerance? Sure, one might be happy with a 100% stock portfolio but are you comfortable with a 400% stock portfolio as described above?
And as an aside, how should debt repayment factor into the Savings Rate he talks about? Obviously racking up credit card debt and paying it off every month shouldnt count but should mortgage/student loan payments count? Or just extra payments? Or not at all? Given the importance of the savings rate, I would really like some insight from Jim on this. This has been my biggest question ever since I found this site in 2018.
No right answers, just a concept to be aware of as you think through asset allocation and debt pay off vs invest questions.
Each year I track my expenses. I want to know how much I spend each year to both help keep it in check now and know how much I’ll need to retire.
I also track how much I save or use to pay down debt. They are both good uses of money.
My mortgage is around 2k. I put the basic monthly payment as another expense. If I apply an extra 3k payment, it’s just as good as savings/investing and is classified similarly.
So a year might look like:
Income: 400k
All taxes & similar: 100k
Spending: 100k
Money saved / extra toward debt: 200k
(Broken down as 164k saved; 36k extra toward debt). And obviously broken down further has well.
Categorize as it’s useful to you. There’s not really a right answer. See WCI pay down debt vs invest blog entry if interested in that topic.
What a great concept Jim. You wouldn’t believe how many times I have talked to a doctor who has $250,000 in cash (earning 0.01% interest) and also has $100,000 in student loans costing them 2.85% interest. I ask why they don’t pay off the loans and they tell me because it is low interest and therefore “good” debt. It makes no sense to sit on all that cash and pay interest on the student loans when you could take some of the cash and earn 2.85% interest on it by paying off the loans. This is a great jump off article for my lecture on Debtabetic Neuropathy in your conference next week. I’m adding it to my Fawcett’s Favorites on Monday.
Thanks,
Dr. Cory S. Fawcett
Financial Success MD
One of the ways I won my husband’s hand was getting him to pay off his car loan (>10% back then) with the money sitting in his checking account getting minimal interest. Tougher getting him to understand a few years later that I couldn’t get him another 20% annual rate like the capricious return he got on a mutual fund (which I apparently should NOT have advised him to get) when he decided a year later he needed the money for a new car. Back when med students (USUHS) had no financial training.
One issue re paying off debt instead of getting bonds or their equivalents (and cash equivalents like emergency fund): if paying off that debt would affect your direst emergency situation. If I lose my job and need to move out of my $800K house it is easier to buy/ rent a $300K house with a $400K mortgage and $400K in the bank/ bonds than with a $800K paid off house up for sale but unable to get a mortgage whatsoever due to job loss. If I don’t cancel my 15% credit card I can always max it back out to the $5K or $15K limit whatever should I lose my usual income stream and need that cash for some reason. (NB better have spouse able to use that credit card still if I die!!!)
Most important point- be very realistic about emergency fund needs. Covid has perhaps taught some of us lessons we needed re how reliable our income and position as doctors can be.
I am still all in for my 100% stock allocation despite still having $110k in student debt and $900K in mortgage, since they are interest rates of 2% and 3.5% (2.1% after tax deductions), respectively. I believe doctors with our steady income can really harness the power of leverage with using debt as a negative bond, as this makes our debt not as callable, as opposed to other workers who may not have a steady income like doctors have. Also Jim, I think there should be some consideration on the equity risk premium, where that really solidifies in my mind the bar which if your interest rate is higher or lower that you should pay off debt or invest.
A lot of docs aren’t feeling quite so confident about their steady income after last Spring.
yeah seriously 🙁 Me and wifie were pretty lucky in that respect. Jim, did you find that docs in LCOL areas fared better in terms of loss of income? Does geoarbitrage include not only taking home more money after expenses, but income protection? I would guess it would- I live in NJ and docs are a dime a dozen and hospital expenses are high, while living in Florida, Texas, Wyoming where docs are sparse and no/low state income/business tax hospital systems need to keep their docs and due to less state taxes don’t need to cut doc salaries.
Absolutely. If I practiced actively in a nearby (medical doc scarcity) county the state would even give me a credit covering about half my state taxes.
I don’t have any real data, but my sense is that most docs made less money than usual last Spring.
If you have debt, there is still a role for owning fixed income, and that’s for risk management. Fixed income allows you to transfer risk using hedging. You can hedge out the risk of known liabilities by using bonds to match assets to liabilities. You can hedge out the risk of unknown liabilities by using cash to match assets to liabilities (emergency fund).
Agreed.
Great article. With regard to the “Different Pots of Money” theory, which I agree with, why do you take the most risk in your kids’ 529 plans? I expect my kids to go to college before I’m old enough to tap into my retirement funds, so why not invest more conservatively in a 529 plan of say, a 5 and 8 year old, versus a retirement account I don’t intend to access for at minimum, 20 more years?
Better question to post as a comment on the post you’re referring to:
https://www.whitecoatinvestor.com/3-reasons-why-you-can-take-more-risk-with-a-529/
But the reason I invest the 529s very aggressively is because the volatility doesn’t bother me as much because I don’t psychologically look at it as my money (and they don’t really observe the volatility) but mostly because the consequences of loss are so much smaller. Heaven forbid they have to choose a different school, work harder during the summers, ask dad to cash flow more of it, or take out a loan. Can’t do any of that with your retirement. Well, maybe choose a less expensive one.
I hold a 100% stock portfolio as a resident. The only thing that stops me from holding 200% stock, via margin trading account, is that if the market dropped in half (like 2008), then my margin account would be liquidated and I’d lose all my money.
If I could somehow borrow money for 2% or less and my account not be liquidated if the market falls, then I’d be all in on stocks at my young age (late 20’s). But a margin call is not a risk I’m willing to take.
You could do it with options like this guy:
https://www.bogleheads.org/forum/viewtopic.php?t=5934
But you better read the whole tale before doing it.
Isn’t ‘negative yield bond’ the proper financial term?
The Bogleheads are certainly enjoying this one. 500+ comments on a thread discussing it:
https://www.bogleheads.org/forum/viewtopic.php?f=10&t=341348
I didn’t think it was that controversial.