Ep 7 - Killing Sacred Cows of Personal Finance, Or, Why I (Really) Don't Love Bonds

Hello, friends. This is Tyler Gardner welcoming you to another episode of your Money Guide on the Side, where it is my job to simplify what seems complex, add nuance to what seems simple, and learn from and alongside some of the brightest minds in money, finance, and investing.
So let's get started and get you one step closer to where you need to be. Today we're talking about something that might ruffle a few feathers in the old finance world, and I get it.
This is one of those sacred cows that I'd like to slowly watch pass away. That sounds terrible, but it's also just how I think about it.
This episode will be dedicated to why I hate bonds, or more lovingly, why I don't love bonds. Now, don't get me wrong, bonds have their place, and I will get to what that place is and why you'd be silly to dismiss such a beloved asset class based on some rambling ding-dongs thoughts.
They serve a function in portfolios, as most things do, and they're often seen as the conservative, steady anchor in a well-balanced investment strategy. They're also

seen as safe by many, a term associated with them that is anything but safe. Bluntly, bonds are overrated, especially when you consider three major factors, all of which we'll get to throughout this episode in more detail.
Interest rate risk, inflation risk, and opportunity cost. And by the end of this episode, my goal is for you to at least see slightly more clearly as to the true cost and potential lack of safety associated with bonds.
First off, I never want to assume my audience is at step two when we need to take a moment to explore step one. A bond is essentially a loan you give to a government, a corporation, or some other entity.
Think about it as you're loaning money to a friend. And now this friend can either be a very trusted friend who is good with paying back your debt, and you might ask for 3% interest on the loan because it's not that high risk of a loan to you.
Or it's a friend who you should never have loaned money to in the first place, but they needed it, as they usually do, and told you they're really good for it this time. For them, well, you might ask for a higher interest rate to account for the fact that they don't have a great credit rating as a friend.
Either way, this friend promises to pay you back with interest over a set period of time. The problem with either situation is that no matter how trustworthy or untrustworthy the friend, that interest rate, the return you get for lending your money, is capped at the outset no matter what happens to the company or the government.
Hence, a bond is classified as fixed income. This is unlike stocks or real estate, which can grow exponentially with unlimited upside.
Our bond guy at my old firm once said it best, with bonds, the single best case scenario is you get your money back with the interest that was promised. Unfortunately, this is where most people leave the conversation and believe that bonds are literally fixed income with interest.
And this is where we need to up our educational initiative to make sure that you know that the best, the single best scenario is getting paid back all of your money. The worst case scenario is that you lose all your money.
Yeah, that can happen with bonds. Now, back to our examples, there are safer bets than others.
Lending money to the U.S. government is backed by the full faith and credit of said U.S.
government. Insert whatever one-liner you want here about what that means to you.
But if you lent that money to your friend who wasn't so trustworthy, well, they might not pay you the high interest rate you expected, and they might default altogether and you never get your money back. If you're interested in learning more about this, this is why there are grades that we have used to classify different bonds, investment grade, non-investment grade, and I would encourage you to do a deep dive at some point into not only the rating systems of bonds in the U.S.
and other countries, but also where that very rating system has been flipped on its head and has deceived investors, aka the subprime housing crisis, where big name lenders acknowledged that they were ranking debts way more casually, let's say casually, than they should have, mostly because they were too lazy to stop and look at what was happening and what was actually backing the assets. Now that we've established that the coolest thing about bonds is that you get paid back, cool, let's look at what's not so cool about bonds.
Number one, interest rate risk, or the hidden

danger of safe bonds. Bonds are often pitched as safe investments.
You loan out a thousand bucks at 3%, you get 30 bucks a year and paid back the thousand bucks at maturity. Well, yes and no.
One of the things that people value about bonds isn't just that they're stable income, but that It's supposedly principal protection, meaning that at any point, if you invest in high-grade investment bonds, you could turn around and sell those bonds for what's called par value, meaning what you paid for them, usually in increments of a thousand bucks. But, and this is a massive but, that is only if interest rates remain consistent from the time that you bought the bond in the first place.
When interest rates rise, the price of your bond will fall. Why? Because newly issued bonds will now offer a higher return.
Let's say instead of 3%, they're now offering 4%. So who on earth would pay a thousand bucks to get your 3% bond when they can now same $1,000 and get a 4% bond? So if you were to need to sell that bond for liquidity, aka principal protection, you would need to do so at what's called a discounted price to make up for the lower interest rate.
And all of a sudden, our principal investment is not quite as protected as we thought it was. We've seen this play out in real time.
The Federal Reserve aggressively raised rates in response to hard inflation data in early 2022, and bond investors felt the pain. The Bloomberg U.S.
Aggregate Bond Index, a benchmark for the entire bond market, was down about 13% in 2022, the worst performance in its history. That's right.
The so-called safe part of a portfolio suffered double digit losses. Think about it this way.
If you bought a 10-year treasury bond in 2021 yielding 1.5%, but new bonds in 2023 were yielding 5%, you would have had a very hard time offloading said 1.5% nonsense. And that's exactly why so many bond funds crashed and burned because they were holding a bunch of lower interest rate bonds that all of a sudden nobody wanted unless they sold at a massive discount and therefore lost a lot of money.
Longer duration bonds are especially vulnerable. If you're holding a 30 year bond and rates go up by just 1%, the value of your bond can drop by 15 to 20% on paper.
And all of this is before we even consider our next silent killer of said sacred cows that also was rampant over the last few years, inflation. And again, I have no idea why we don't talk about this daily with the fixed income parts of our portfolio.
No, you're not getting a 3% return on a bond. You're getting a 3% pre-inflation return, aka nominal, and you're getting a 0% real return.
Worse, if you're looking to buy a bond yielding 3% to 4% for the next decade, as I have done as a portfolio manager when 3% to 4% looked great, but then inflation is running at 4 4-5% or higher as it recently was, you're losing purchasing power each and every year. Again, not really what my definition of principal protection would be.
Historically, inflation has averaged around 3% per year, but in 2022, we saw inflation peak at over 9%. Even if it settles at a long-term average of 3-4%, that means bondholders could still be treading water at best.
One alternative and potential solution is to buy what's called Treasury Inflation Protected Securities, or TIPS, which adjust for inflation, but they come with their own quirks and aren't always the best deal with usually much smaller real returns. The reality is, over time, inflation erodes fixed income returns.
And that's particularly hard to stomach if you have locked in these bonds for more than a few months to a few years, making bonds a questionable long-term play compared to assets that can actually grow and outpace inflation, like stocks, real estate, or even well-managed businesses. But those risks are both nothing in the face of why I ultimately will never invest in bonds.
And no, this is never advice for you, but it is worth thinking about on a deep level. By investing in one thing, you can't invest in another.
This may seem painfully obvious, but sometimes the most meaningful and timeless truths are also the most simple and straightforward. If you retire at 60 and start investing in bonds, for every dollar you invest in a bond, you are sacrificing $1 that you could allocate to something that has more potential, or any potential, to grow and outpace inflation and mitigate tax liabilities.
Historically, the S&P 500 has returned about 7% annually post-inflation. and via incredibly tax-efficient vehicles, while bonds typically return around 1-2% post-inflation.
That's a ridiculous gap over time. If you're investing for long-term wealth, would you rather have an asset that gives you 2% and doesn't compound, or one that offers you 7% and does compound? The difference over 30 years is staggering.
And I can hear people shouting in the back, but Tyler, bonds are safer than stocks. Well, honestly, not really.
This is an inherited narrative that just doesn't hold water. Beyond interest rate risk and inflation risk, we're now able to invest in stocks via tax-efficient, low-cost index funds and ETFs.
This is important because one of the age-old fears of stocks is that you could lose it all. And yes, if you invest in individual stocks, especially just a few of them, you could.
It would still be pretty dang far-fetched, but you could lose it all. But if you invest in an index fund that tracks 500 of the most profitable and stable companies in the United States, I'm sorry, but we don't need to be statisticians to understand that the risk is all but zero of having that go to zero.
The odds that a diversified stock portfolio will somehow go to zero are, well, nothing in finance is certain, so I'll say 0.00001. And now to respond to the other critics in the back.
But what about volatility from one year to the next? Yes, stocks are more volatile, meaning you can't rely on any one year or day even being as a stable store of value for a stock portfolio. It can and does fluctuate a few percentage points in even a day.
But if you have a long time horizon, and yes,

with extended life expectancies and improved health conditions, most of us do, even at 65, that volatility smooths out and the rewards simply outweigh the short-term bumps. Now, do bonds ever make sense? Sure.
But here's the only time they do. When you reach a point in your financial accumulation where you can say, I don't need more money and I can survive off of two to three percent of this principle.
Remember, you can't use four to five percent because that's pre-inflation and pre-tax. That's when bonds might make some sense.
As in, you're already there and you want to prioritize some protection, even though we have seen it's certainly not full protection, over growth. But the truth is, for most of us, we can't sacrifice growth for principal protection.
We just can't. Even if you have a million bucks at retirement, a number a lot of people would love to have, and you ascribe to the age-old nonsense that you can only take 4% off of that per year, that's $40,000 a year pre-tax, pre-inflation.
What? You're going to live off of $25K a year in retirement? We need growth. Period.
So for most investors, especially those with decades ahead of them, an over-reliance on bonds is a costly mistake and can end up really hindering your ability to be as financially free as you'd like to be. The key takeaway here is not to not invest in bonds, but always to think critically about where you're putting your money, and if you're putting it in one place, what are you missing out on in another? Bonds have very real risks, interest rate risk, inflation risk, and the biggest of all, opportunity cost.
So before you blindly follow the 60-40 portfolio mantra of our parents, ask yourself, is this really the best way to grow or even protect my own wealth? That's all I've got for today. And as always, I hope it proves somewhat helpful and gives you something to think about throughout the week.
Thanks for tuning in to your Money Guide on the side. If you enjoyed today's episode, be sure to visit my website at tylergardner.com for even more helpful resources and insights.
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Until next time, I'm Tyler Gardner,

your money guide on the side,

and I truly hope this episode got you one step closer

to where you need to be.