Conventional wisdom has it that bonds are the safe haven investment and that they are the alternative to stocks. When stocks are drifting downward, the logical place to put your money is into bonds. Your biggest investment decision is to decide how much asset allocation to put into bonds versus stocks.

Unfortunately, this conventional wisdom came to prominence in the last 20 years which happens to coincide with a rather large bull market in bonds.

Unfortunately, bonds have started to turn around. If you look at the price performance of bonds over the last year (or really, since the peak back in June of 2003), the prices have been down across the board. The 30 year, 20 year, 10 year, and inflation adjusted bonds are all in a downtrend. The only bond index/etf available that is in an uptrend is SHY which focuses on 1-3 year bonds. (I like StockCharts for this because their charts include the dividends provided by the funds — look at the charts on BigCharts and you’ll see an even more pronounced downtrend, even in SHY.)

Let’s look at the case for bonds in terms of risk and reward. The reward is that you have a pre-defined constant stream of dividends, potential capital appreciation, and high safety (the potential for default is lower as long as we’re not talking about junk bonds). The risks are that there might be capital losses, inflation is greater than the dividend stream, and opportunity cost. The biggest risk, in my opinion, is that inflation outstrips the dividends consequently causing capital losses.

If the world economy begins to slow, there could be a flight to safety (bond buying) that would help the price of bonds. Inflation could also magically come under control, and foreign buying of treasuries could continue to increase forever… But I wouldn’t count on anything more than a 3 to 6 month rally. The TLT ETF had an 11% drawdown from peak to trough in the last 52 weeks (that’s with dividends included, without dividends it would have been a 14% drawdown). Can bonds rally enough to make up for the potential drawdowns?

Since most investors buy bonds via a fund, they don’t have the fail-safe of allowing a bond to mature and reclaiming their original principal. Bond funds are marked to market, which means once the price goes down, you’ve lost the money.

Incidentally, even TIPs don’t provide the safe haven that they should. TIP yields are tied to the official CPI numbers as released by the government, which means you’re at the mercy of the reporting anomolies for your yield.

The argument for bonds is shaky, and it shouldn’t be the default answer for “not stocks”. I know many people (myself included) have their hands tied when it comes to investment options in the 401(k)s… complain to your retirement account administrator to get more options. (I’ll write a separate post on what categories I think should be included in asset allocation besides stocks and bonds. The short answer: cash, gold, commodities, international bonds, international stocks, real estate/REITs, timber, etc.)

I have a large chunk of my own money in “not stocks” (a.k.a. bonds) but I have chosen the lesser of the evils available to me. I choose stable value funds where available, or money markets and CDs when necessary. I actually prefer money market funds over bond funds right now. You get very close to the same yield (if not a better yield), less risk of capital loss, and less volatility.

Right now just about everything looks shaky (bonds, stocks, commodities, gold, etc.) and if you don’t have to be in the market, I’d recommend standing aside in cash (a money market fund). My guess is that we will be able to buy almost all assets at lower prices within the next year or sooner.

I guess you have to ask yourself… are you trying to earn an above average return on your investments or are you just trying to put it somewhere as a store of value over time. If the latter, bonds and the S&P 500 are decent ways not to lose too much money. If you’re trying to earn an above average return, bonds are not my vehicle of choice.

The “problem with bonds” that I speak of applies to those who want an above average return. If your timeframe is long and your expectations are low, you probably can get a positive return out of bonds. If you believe in relative performance, bonds may do better than stocks (a.k.a., they may lose less than stocks).

Hey, if there was an easy answer, everyone would be retired, right?

[Note: Stable Value Funds are typically only available in 401(k) plans, so take advantage of them there if you have the option. They typically have higher yields than CDs and equally low volatility.]