Financial planners like to put clients into investment portfolios that are neatly boxed in, such as 60% stocks and 40% bonds, or 70%/30%. In my opinion, such a portfolio split is ok only after all of the client’s debt is paid off. At least, all non-mortgage debt should be paid off prior to investing in any bonds, and even then it is debatable as to whether it makes sense to invest in bonds.
Spread
Mortgages now are in the 4%-range, as are perhaps car loans. Student debt is now in the 8% range. Credit card debt is in the high-teens. Why would you invest in say a bond fund that pays 5% while at the same time you have a mortgage, student loan debt, a car loan, and maybe even unpaid credit card balances? It doesn’t make economic sense. Banks make money on their “spread”, which is the difference between what they earn on loans and what they have to pay to depositors. If you have unpaid loan balances, you probably have a negative spread, meaning that you are borrowing money at a higher rate than what you are earning by lending it out. Investing in bonds is equivalent to lending money to the party from whom you are buying the bonds, including the US Government if you are buying US Treasury Securities. No bank would stay in business if it lent at a higher rate than that at which it borrowed. You shouldn’t, either.
Mortgages
Mortgages are somewhat different because individuals can deduct the mortgage interest on their taxes. However, the new 2018 tax law will increase the Standard Deduction to $24,000 for Married Filing Jointly, which means that, unless your itemized deductions (including mortgage and all other itemized deductions) exceed $24,000, then it is unlikely you will opt to deduct your mortgage interest. The new tax law also reduces the amount of mortgage that can be deducted from $1 Million to $750,000. The point is that the tax favorability of mortgage interest is reduced starting in 2018. So, in my opinion, it is a push as to whether it makes sense to buy a bond fund or pay off or pay down your mortgage. The money in and the money out will be about the same even after taxes.
Less Current Income Needed
In addition to portfolio balance and risk mitigation, another important reason why investors buy bonds or other debt instruments is for current income. They need the incoming interest payments to live on. If you pay down debt, you reduce your burn rate, meaning that you will need less income from the bonds that you are buying. By reducing your monthly outflow, you will accomplish the same goal of balancing your income and expenses at the end of each month as you would have had you kept your outflow the same and increased the amount of your inflow. It is easier and makes more sense just to reduce your outflow by paying down your debt burden.
IMO
It is a different story in your retirement account because you can’t use retirement account money to pay off debt. Do the 70%/30% allocation split in your 401k. However, if you are sitting there with a mortgage, car loan, student loan, or especially credit card outstanding balances, do yourself a favor that makes complete financial sense and use any excess investment money that you were thinking about allocating to a bond fund and instead allocate it toward paying down those loan balances. Also: Pay down the loan balance with the highest interest rate first. This may be the subject of another blog post.