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Consider a person who constantly worries about stock prices, and has a history of severe panic during stock market crashes. This person also happens to hold a diversified portfolio of investment-grade bonds that are always held to maturity (not bond ETFs but individual bonds). This person is psychologically unsuited to owning stocks, but appears to have no such problem with his bond portfolio. Possible reasons:

  • payout on bond maturity is a defined amount, giving him comfort that money will be repaid, and allowing him to ignore day-to-day price fluctuations.
  • less potential for panic because there is less external influence (less news, less discussion, less conversations with friends).
  • less temptation to sell (due to a combination of a known eventual payout and low liquidity).

He wants to stop worrying about stock market fluctuations and the emotional roller-coaster. He recognizes his emotional weakness when it comes to stocks. As such, he is planning to avoid the stock market and place 100% of his portfolio in a basket of investment-grade bonds with different maturities. Is this a good idea? What are the possible pitfalls?

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  • Surely the problem is that the amount of money you can make from bonds is very low?? If that is a "problem" then that is the "problem". – Fattie Sep 30 '20 at 11:52
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    @Fattie depending on what "bonds" you are talking about you can make 8-10% on bonds (e.g. high-yield corporates), but they have proportional risk as well. – D Stanley Sep 30 '20 at 12:22
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Is this a good idea?

It's not a terrible idea, but it sounds like it's based mostly on emotion, so it may not be the best move financially. It's a trade-off of reduced risk and (possibly irrational) anxiety for most likely lower return. There are segments of bonds that can earn 8-10% on average, but with that kind of return you're bringing in different risks (described below). The fact that those risks aren't talked about like stocks may be a source of emotional comfort, but the risks are very real.

What are the possible pitfalls?

The main risks for vanilla, fixed-rate bonds are interest rates and defaults. As "government" interest rates go up and down, so do bond yields. If interest rates go up, the value of bonds goes down (because your year-old bond that ays a 4% coupon is worth less than a newer bond that pays a 5% coupon). It's (mostly) true that your coupon and redemption are guaranteed, but there's an opportunity cost if rates go up. Considering that rates are at all-time lows, it seems like a tough time to go all-in on bonds.

The second risk is default. Government bonds are virtually free of default risk (since the government can always "print" more money to pay coupons), but they have the lowest interest rates available (currently close to zero in the US, and negative in some countries, depending on the maturity of the bond). Corporate bonds have a relatively low risk of default, but it does happen, and not just because of a global pandemic. If a bond issuer fails to make even a single coupon payment, they are in default and most likely will declare bankruptcy. That means that you might get some of the bond's value back eventually, but it may take months and you may only get a fraction of the value. So it is a very real possibility that you can lose money even on seemingly "safe" bonds.

There are other types of bonds (floating-rate, callable, convertible, inflation-indexed, etc.) that have different risks, but the most common bonds are fixed-rate bonds that have the two risks described above.

You can diversify bond investments just like you can with equity investments, which reduces the overall effect of defaults, but with diversification comes less risk and less expected return, so you're really just betting on interest rates at that point (or hoping for fewer defaults than expected).

So one could invest in bonds and either ignore these risks or trade the emotional roller-coaster of the stock market to the smaller roller-coaster of interest rates.

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