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Bonds and mortgages are not exact opposites

Many thoughtful investors believe that holding bonds at the same time that you have a mortgage doesn’t make sense. The common reasoning is that they are perfect opposites: with bonds you lend money and receive interest, while with a mortgage you borrow money and pay interest. That means the net benefit (or cost) to you is the difference in the interest rates multiplied by the amount you hold in bonds or the amount of your mortgage, whichever is smaller. Typically this is a cost since mortgages are likely to have higher interest rates than bonds. For example the DEX Universe bond index currently yields around 2.5%, while our mortgage rate is 2.99% and many people are paying even higher interest rates.

On that analysis you might conclude that we would pay less interest by using the bond capital to pay down the mortgage. However there is an additional factor in this equation: changing interest rates. We know that interest rates are more likely to go up than down in the future. When interest rates goes up, the effect does not cancel out cleanly. The bond owner will lose money since the value of existing bonds goes down when interest rates goes up. And the mortgage holder loses money since mortgage payments go up when interest rates go up. In this sense bonds and mortgages are worse than opposites: they both lose money at the same time.

With a fixed rate mortgage this could leave the bonds yielding more than the mortgage interest rate for a few years. However there would also be a capital loss on the bonds. A rule of thumb I’ve heard is that the duration tells you the number of years it takes for the higher yield to pay back the drop in the price. With a duration of 6 – 7 years our bond holdings are not attractive by that measure.

All of this makes a pretty compelling argument to not hold bonds when you have a mortgage unless you happen to find some fixed income that yields well over your mortgage interest rate, like our MIC holding that’s giving us 5% now. The downside is a lack of flexibility in rebalancing since you can’t easily increase your mortgage to invest more in stocks. However if you have substantial monthly contributions to your mortgage and investments, like we do, you can redirect those as appropriate based on changing conditions.

Based on this I’m considering moving all our bond holdings into stocks. We don’t want to pay down the mortgage too fast at this point (it has under 15 years left) since the interest rates are so low. Bonds are only a small part of our portfolio so they don’t have a major impact but getting rid of them would put us right where I want to be: paying very low interest rates while maximizing the amount we have in equities to earn long-term returns.

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