Bonds or Safe, Reliable Assets

In my posts about Leveraged Barbell Portfolios, I talk about bonds as being the primary holding for investors. Sometimes I mention the term "quality bonds". However, I think it is important to clarify what I precisely mean when discussing bonds in this context.

I tend to use bonds (or "quality bonds") as a proxy term for a safe, reliable asset. There are many opinions on what that means, but I think we can identify some characteristics of a safe, reliable asset.

  1. The asset is not likely to lose value in the short term. (Positive expected nominal returns).
  2. The asset is likely to maintain or increase its purchasing power over longer time periods. (Positive expected real returns).
  3. The asset is liquid. (Active marketplace, low transactions costs, easily divisible.)
  4. The asset is not likely to suffer from expropriation or cancellation (Legal forms of property loss.)
  5. The asset is not likely to be stolen or destroyed. (Illegal forms property loss.)
  6. The asset is durable. (Natural forms of property loss.)

There may be more identifiers of safe, reliable assets, but I think this is a pretty good list to start with.

Quality Bond Characteristics

By these metrics, we should consider the attributes of what I describe as "quality bonds". Quality bonds are high-rated shorter duration government bonds and certain high quality shorter duration corporate bonds.

They almost always have positive nominal returns. In any event, drawdowns in nominal terms are minimal and the coupon can be held until expiry where the face value is paid.

Quality bonds do not always have positive real returns, but they tend to be positive over time. Inflation risk and interest rate risk can be mitigated through building a portfolio of laddered shorter duration bonds. This means interest rates on individual coupons are constantly updated. Most shorter duration bond ETFs provide this service as part of their nature.

These bonds are highly liquid. With face values as low as $100 per coupon, it is easy to sell a small portion of overall bond holdings. In addition, transaction costs are tiny and the trading market is absolutely massive. ETFs can add obvious liquidity benefits for retail investors.

Bonds can suffer from expropriation or cancellation, particularly government bonds from higher risk countries and lower quality corporate bonds via bankruptcy. However, I think this risk can be alleviated quite easily with some basic screening techniques for issuer quality.

Bonds are very unlikely to be stolen or destroyed through criminality. Brokerage accounts, where these instruments are typically held, are insured. If your brokerage is in a country with a good track record for property rights, as most are, the risks are low.

Unlike physical assets that may be subject to deterioration, bonds do not have these properties. They are electronic, ownership is carefully recorded, and they don't physically erode.

Other Real Assets

Other assets that may be typically thought of as safe do not share as many of the same characteristics of safe, reliable assets as quality bonds do. Some of the other assets stated as being safe with stable value include physical gold and silver, productive land, real property improvements, live agricultural assets, and resource extraction rights.

Physical precious metals have a long history and extensive following as being the premier safe asset. In many ways I like precious metals. However, precious metals are not liquid and suffers from illegal property loss risk. The liquidity component may change if we ever move back to a gold standard, but a lot of things would have to change before that happens.

Productive land is in many ways a great asset. However, it is not liquid. There are also risks for durability and legal property loss, but these can be mitigated by choosing a country that respects property rights and a location that is less prone to natural disaster.

Real property improvements (buildings, etc.) are not liquid and not durable. Unlike productive land, buildings and other improvements must be constantly maintained. Eventually, many are simply replaced or removed as the maintenance becomes to burdensome or the characteristics of the area change. Like land, selling real property improvements can be expensive with lots of time and paperwork involved.

Live agriculture assets are interesting. Forests, perennial crops, cattle herds, and farmed or ranched fisheries have many characteristics of safe, reliable assets. They tend to maintain their value over time in real terms and have many liquidity features. However, they can suffer from illegal property loss and may not always be durable (forest fires, disease, etc.). They also require tending and maintenance to ensure long-term value characteristics.

Resource extraction rights, such as mining rights, fishing rights, water rights, agriculture production rights, and so on are essentially legal assets. Though not always, the markets for these assets can be very limited and I believe they carry significant risks. They can suffer from legal property right concerns as they are often politicized due to their monopolistic nature. However, they are often durable and not likely to suffer form illegal property loss with some screening.

Bigger Picture Views

As I've stated on this blog many times before, I believe most investors should have a sizeable allocation to safe, reliable assets. The go-to asset in this context should be quality bonds. While not perfect, they are as close to a safe, reliable asset that an average investor can access on the market today.

However, as an investor's portfolio grows, there may be less reasons to only choose quality bonds as the safe, reliable asset. As the list of alternatives above shows, there are other assets that carry many positive characteristics and returns which are likely to be different from quality bonds, or those growth charging equities.

As well, risks and priorities begin to shift as a portfolio grows. It is reasonably safe to assume that investors will always look for their assets to have positive nominal and real returns over time, that they don't suffer from illegal or legal property loss, and that the asset exhibits some durability or compensate for loss.

The biggest difference may be in the form of liquidity needs. If you have a $500,000 portfolio with $400,000 in safe, reliable assets, it is essential these assets are liquid as you may need to tap into the portfolio and don't want to distort your risk profile too much.

However, if you have a $5 million portfolio with $4 million in safe, reliable assets things are different. The likelihood of needing more than a few hundred thousand for any purpose is very low. At this point, assets like productive land, physical precious metals, real property improvements, and agriculture assets may become very appealing as a component of the overall portfolio despite their lower liquidity characteristics and other management requirements.

As portfolios get even larger, additional risks may be taken on because they are less likely to cause large disruptions in total wealth in their lower probability, large impact risks. For example, resource extraction rights may enter the portfolio. There is the risk of total loss, but there is the advantage of steady, monopolistic investment returns on that asset for a long time.

When I discuss bonds or quality bonds as a core part of the portfolio, it should always be taken in a wider context of the investor's situation. I am generally referring to safe, reliable assets that are suitable for the investor.

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.

2 Replies to “Bonds or Safe, Reliable Assets”

  1. Hi Daren.

    For a moment there I thought you were announcing that you had bought some forest land or a farm 🙂

    “precious metals are not liquid and suffers from illegal property loss risk“.

    I take you are referring to hiding the ingots and coins under the bed. Liquidity and property loss risk will not be a thing if you buy them as a commodity via an online discount broker.

    Price of things like a gold ETF for instance swing a lot on the short term. I can see how in the long term gold could keep up with inflation; but it seems to me gold could lose (or win) a lot on a short term basis. How then can it be considered a “safe, reliable asset” as per your definition? Is it not violating the 1st bullet point?

    1. Daren (Editor) says:

      I would say that quality bonds are the best reflection of a safe, reliable asset in todays markets. The other assets are often quoted as safe and reliable by their proponents, but they lack in some features. Gold, even in ETF form or futures has its drawbacks as you point out and I don’t think it replaces quality bonds in the portfolio.
      I like gold and think it has a small place in portfolios, especially as portfolios get big. In many ways it has features of a commodity, currency, and “fear index” all in one. That has value, but it does not hit all the features of a safe, reliable asset that I’ve identified.

Leave a Reply

nine + one =