A reader recently sent in this question on asset allocation:
I’m an investing newbie. Last year, I started investing in all four TD e-Series Mutual Funds in my TFSA on my own after reading your posts. I currently have a 30 percent allocation to bonds. Should I keep investing in TD Canadian Bond Index (e-Series) with interest rates forecasted to go up? Or should I cut down on the bond fund and allocate more into the other stock index funds?
Bonds have been terrific investments for a long time now. As of Sept. 30, 2013, Canadian bonds (as measured by the DEX Universe Bond Index) have returned 5.63 percent over 5 years and 5.22 percent over 10 years. Canadian stocks (as measured by the S&P/TSX 60 Index), on the other hand, had returned 3.72 percent and 8.45 percent respectively during the same time periods albeit at a much higher volatility including a significant stock market crash. Therefore, the natural inclination of many investors would have been to look at the recent past and concluded that they are better off in bonds than in stocks. Asking whether one should avoid an asset class after it has experienced a huge run up if therefore an insightful one.
Many smart asset allocators have publicly voiced the opinion that investors are likely going to experience poor returns in bonds. In an article in Fortune magazine last year, Warren Buffett has this to say about bonds: Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt: “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.”
Even if one agrees with the sentiment that expected returns from bonds will be poor, it still makes sense for an investor to hold some bonds. For one thing, the forecast of poor bond returns could turn out to be wrong. 10-year Government of Canada bonds are yielding 2.5 percent these days. 10-year bonds in Japan yield just 0.6 percent. If Canada were to, God forbid, experience a period of falling price levels, bonds will turn out to be better investments than stocks.
Bonds typically play a defensive role in a portfolio. Investors hold bonds to help them get them through the inevitable rough patches in their stock investments. When stocks fall sharply, bonds usually hold up their value because investors take flight to safety. Therefore, an investor’s overall portfolio does not experience as sharp a drop as their stock holdings. And if stocks fall far enough, investors can rebalance by selling some of their bonds and buying stocks at lower prices. This rationale for owning bonds holds up even if the prospective returns from bonds is poorer than usual.