The Case For A 0% Bond Allocation Is Weak

Includes: HYG, IEF, LQD, MUB, SPY, TLT
by: The Financial Lexicon

I recently came across the Seeking Alpha article, "The Case For 0% Bond Allocation." As I clicked the link, I envisioned a rock-solid argument for why investors should allocate no money to bonds. Unfortunately, the article was anything but a rock-solid argument for why a zero percent bond allocation is prudent. Why did the article make a weak case for allocating no money to bonds? The author made the same mistake so many other financial writers make when stating something similar: He focused solely on the Treasury market (NYSEARCA:TLT).

Treasuries alone do not make up the bond market. At a minimum, an article titled, "The Case For 0% Bond Allocation" should discuss Treasuries, corporate bonds (NYSEARCA:LQD), and municipal bonds (NYSEARCA:MUB). To make matters worse, the focus wasn't even on the entire Treasury curve. Instead, it was on what is likely the least-widely-owned part of the Treasury market, intermediate-to-long-term Treasuries (NYSEARCA:IEF).

I am an advocate of building a diversified allocation to bonds that has a "real" yield. Perhaps surprisingly to some, even in today's interest-rate environment, a bond allocation with an after-inflation positive yield can still be built. But long-term-oriented investors focused solely on the Treasury segment of the bond market will struggle to build a diversified portfolio of individual bonds with real yields. In order to accomplish this, investors need to also become familiar with investment grade corporate bonds, non-investment grade corporate bonds (NYSEARCA:HYG), and municipal bonds. The author's attention to purchasing power is a positive aspect of the article, and he deserves credit for bringing up that important point. But just because investors will struggle to capture real yields from one part of the bond market does not mean the same will occur in other parts of the bond market.

Additionally, regarding purchasing power, the author doesn't discuss the fact that bond coupons can be reinvested. In the event the 3.5% to 4% inflation the author mentions ever materializes, investors will likely have the opportunity to reinvest bond coupons at higher yields.

Another point worth mentioning concerns the following two sentences from the article's conclusion: "That's why it is borderline investment malpractice to recommend long-term bond funds right now-they have no chance of matching the overall performance of a prudently selected basket of stocks over the long-term. Unless we enter a period of deflation or very low inflation, there is no way that a portfolio of Treasury bonds purchased today does not decrease your purchasing power and effectively make you poorer over the long term."

Regarding the just-mentioned quote, there are three things worth pointing out: (1) It doesn't seem appropriate to compare the performance of bond funds to a basket of individual stocks. In this case, comparing bond funds to the S&P 500 (NYSEARCA:SPY) might be more appropriate. Also, keep in mind that investors who have the expertise to prudently select a basket of stocks will also have the expertise to prudently select a basket of individual bonds to be held to maturity. A basket of carefully selected individual bonds, even in today's interest-rate environment, can offer yields far greater than those of many popular dividend-paying stocks. As Seeking Alpha readers who follow my newsletter know, in addition to common stock and preferred stock ideas, I routinely identify many individual bonds trading at attractive "real" yields for the given level of risk. (2) To state that bond funds have "no chance" of matching the overall performance of a basket of stocks seems a bit too prophetic. And (3), regarding "Unless we enter a period of deflation or very low inflation," there is a case to be made that despite out of control healthcare costs and rising college tuition, we are already living in a period of very low inflation.

As someone who currently owns a broadly-diversified portfolio, including a whole host of dividend-paying stocks and individual bonds, I think it is prudent to have a healthy balance between stocks and bonds. The definition of "healthy" will vary depending on your investment objectives, risk tolerance, and time horizon. But until someone convinces me otherwise, I think a balanced and diversified portfolio should include an allocation to bonds that is greater than zero.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long numerous individual stocks and individual bonds (including Treasuries, and investment grade and non-investment grade corporate bonds).