Gentlemen Prefer Bonds

September 15, 2002

August started off well enough with the market continuing up after a late July rally. Then it sort of petered out. The month wound up being pretty flat across the board - S&P500, Dow, NASDAQ, small cap value stocks etc where all rather stagnant for the month. Emerging market bonds came back strongly after a few weak months.

The one "shinning" star was US Government Bonds. Again. Corporate bonds weren't half bad either, but mostly the safer bonds of the lot. Junk bonds were only moderately strong.

How hot are "safe" US government bonds? They were up around 4% in August, after a big run in July amidst the market chaos. In fact, long-term government bonds, the kind the government recently decided they didn't need to issue anymore, are up over 12% this year so far. That's a lot of money to make in a safe investment.

How are they up 12%? You thought yields were low on bonds, right? Well, right. They are low. In fact, a 10-year government bond yields below 4% right now. The rest of that return comes from "capital appreciation" - meaning if you owned a bond that yielded, say, 5% for 10 years, and rates came down, your bond is more valuable than those yielding less - 1% a year for the next 9 or so years. Well, if you tried to sell that bond you bought last year, you'd find a willing buyer to take it off your hands for about 6-8% more than you paid for it. That on top of the "yield" you earned owning the thing for a year and voila, there is your double-digit total return. Pretty nifty. Yields down, bond prices up.

Unfortunately, the same thing can happen in reverse when yields (interest rates) go up. Nobody seems to care about that these days, since the past performance of bonds has been so strong, and bonds are so darn safe. Safe, and the government isn't buying $6,000 shower curtains with your hard earned money like certain ex CEO's who's initials are Dennis Kozlowski. 

Government bonds are only "safe" when it comes to defaults. They are very not safe when it comes to interest rate risk, the risk rates will rise and cut your safe bond investment buy 15% in short order. We're not saying you should abandon bonds and invest all your money in stocks now - just watch the allocation to "safe" bonds. The money has largely been made investing safe these last few years, don't expect double digit total returns much longer in this area. On the other hand, some "less safe" bond classes can balance out a portfolio quite nicely, even though you are giving up some interest rate risk for default risk.

Are stocks cheap then? Not by any historical measure. Except one - in comparison to bonds. You see, as bond yields go down, the chance that stocks are going to outperform bonds over 5 or 10 years goes up. Right now for instance, if it takes the Dow 10 years to retake its old highs, you will have a total return including dividends in excess of what you would get buying 10 year bonds and sitting on them. Any further decline in stock prices (or decrease in bond yields) will only make stocks more appealing in the long term. This analysis has nothing to do with short-term risk, as a stock portfolio at any valuation is risky in the short term. In the long term, stocks are only risky if you pay a steep price for them.

If bond yields fell to say, 1% (which sounds patently absurd to you and I, but it is what someone speaking for Wall Street's "experts" on 'Cashin' In' assured me was going to happen) and stocks stayed where they are, then the dividends (remember those things nobody cared about a few years ago) of stocks would be higher than bond yields. That means if you bought a stock index and sat back for 30 years you'd make more money than if you owned bonds EVEN WITH NO MOVEMENT IN THE STOCK PRICES. I almost hope bond yields fall to 1% so we can shift all our model portfolios into stocks.

I've mentioned how investors can't trust "research" from Wall Street when there is some sort of vested interest at work, which is basically all the time. Recently the press has been quoting Bill Gross, manager of the world's largest mutual fund, the Pimco Total Return fund. It wasn't always the largest, stock funds like Vanguard 500 and Fidelity Magellan have held that honor for years, but then, bonds are what everybody has just got to own these days. 

Mr. Gross recently took a break from his day managing a cool quarter trillion in bonds to pen his reasons why the Dow should be at 5,000 because dividend yields are so low historically, and much of the returns investors have made in stocks have been from the dividend yields, not earnings growth.

On the surface, he is right. The piece would have been much more timely had it been written at NASDAQ 5000 in early 2000, when dividend yields were REALLY low compared to bonds, but better late then never. I'm not going to harp on how everything Mr. Gross does is bond related, so he probably never had much good to say about stocks ever, even back in 1982 at the start of a near 20 year bull run of historic proportions, but I will say that in his long rant on the evils of stocks, Mr. Gross fails to mention that most of the returns in bonds has been a result of falling interest rates. In fact, your future returns in bonds have very much to do with the current yield, which is as historically low as dividend yields. Maybe someone should get Warren Buffet to write "Treasury Bond 6%" to contrast with Gross's "Dow 5,000". And the media should get another star for giving a microphone (and a TV camera) to whatever investor is behind whatever has worked for the last few years, with no regard to how they may do in the future. Remember all those tech fund managers on TV and on magazine covers a few years ago going on and on about market share and revenue growth? Thank you media for helping us learn about yesterdays hot investment ideas, right before they tank.

The sad reality is, all investment choices are pretty lousy right now: Stocks, Bonds, Real Estate, even cash. Lousy because the likely future returns are pretty bleak. I like to think we're doing the best we can given the cards we are dealt. Everyone of our model portfolio was up a bit last month, so we must be doing something right, not that the short-term returns are everything. For more on our model portfolios last month, click here.