TCS Daily


Stop the Dumb Bond Jokes

By James K. Glassman - August 20, 2002 12:00 AM

In what may be the best signal yet that the stock market has hit bottom and is on its way back up, this week I am going to write about bonds.

Regular readers know that I am not fond of bonds as long-term investments. History has convinced me that they return far less than stocks and, because of inflation, are about as risky in the long term. The short term is another matter. If you cannot put your money away for more than five years, then bonds are your ticket.

Lately I have been hearing from many readers who have become so frightened of stocks that they are moving some of their long-term money into bonds -- despite the lowest interest rates in a generation. Does such a strategy, inspired in many cases by panic, make sense?

First, some basics: A bond is an IOU -- a piece of paper (or, more likely, an electronic entry) you receive in return for making a loan, typically to a national government, a state or local agency, or a corporation. Most loans have fixed terms and pay fixed rates of interest. For example, the U.S. Treasury recently sold an issue of notes (as intermediate-term securities are technically called) that mature on Aug. 15, 2012, and pay 4.375 percent interest (this fixed rate is called a coupon). A T-note maturing in five years recently carried a coupon of 3.25 percent; a two-year note, 2.25 percent.

If you buy a bond at its full face value, the yield (interest as a percentage of price) that you receive is the same as the coupon. For example, pay $10,000 (or 100 percent of the face value) for the 10-year note above, and the Treasury will pay you $437.50 a year for the next decade and then will hand the original $10,000 back to you. There is essentially no credit risk with Treasurys -- as there might be with a bond issued by, say, WorldCom or even General Motors.

Still, there are other risks to consider. If inflation averages 3.1 percent for the next 10 years -- as it has since 1926 -- then the $10,000 you get back in 2012 will be able to buy only about $7,500 worth of goods and services, as they are priced today. The value of your principal will be eroded by one-fourth. In other words, your bond will be paying average annual interest of just 1.275 percent after inflation.

Also, interest rates are at historic lows. If they rise (usually because of fears of inflation), then your $10,000 bond won't be worth as much if you decide to sell it on the open market. Who wants to own a bond paying 4.375 percent when new bonds of the same type are being issued with coupons of 5 or 6 percent? Under this scenario, if you have to sell your bond before maturity, you'll have to mark it down to find a buyer -- perhaps to $8,000. Remember this: Bond prices rise when interest rates fall, and they do the opposite when interest rates rise.

Like stocks, bond prices fluctuate from minute to minute as investors buy and sell them on established exchanges. Their prices (and, thus, their yields) change because of changes both in the perceived ability of companies or governments to pay back their loans and in the general interest-rate climate. I am happy to say that I bought a Treasury note a few years ago that carries a coupon of 7 percent and matures in 2006. I paid full face value for it -- or a price of 100 in bond jargon -- and it was trading last week at 113.94. If I wanted to sell it, I would get about 14 percent more than I paid. But I have no intention of selling -- I like getting 4 percentage points more in interest than I would with a similar freshly issued note.

At the end of the year, you can add a bond's interest yield to the rise or fall in its price and get its total return. Of course, if you buy a bond when it is issued (at 100) and sell it when it matures (also at 100), the price won't be a factor at all -- only the interest.

Don't forget taxes. Imagine you are in the 30 percent bracket. Of the $437.50 interest you get a year, $131.25 goes to the Internal Revenue Service. (Federal bonds are exempt from state taxes; state, or municipal, bonds are exempt from federal taxes and, in most states, exempt from state taxes as well for residents.)

Between taxes and inflation, you come out about even.

Of course, a break-even investment looks pretty attractive these days with the benchmark Standard & Poor's 500-stock index down 20 percent for the first 7 1/2 months of 2002, Germany's DAX down 28 percent and Japan's Nikkei down 7 percent. As investors switch from stocks to bonds, the increased demand is driving up the prices of bonds and thus driving down their yields. (Non-U.S. debt is also providing low yields. German government bonds maturing in five years were yielding 3.9 percent on Wednesday; British 10-year bonds, 4.5 percent.) Think of it this way: Borrowers with sound credit -- such as U.S. and European governments -- don't have to offer high rates to attract lenders.

In the meantime, most corporations are just trying to keep their heads above water; they aren't doing a lot of new borrowing to expand their businesses. So, even though national governments are returning to the debt market to fund their growing deficits, the supply of new bonds is relatively low and the demand is high. Again, rising prices and falling yields.

A final factor is the activity of central banks all over the world, which control very-short-term interest rates. Over the past few weeks, the Federal Reserve and its counterparts in other countries have grown more worried about a renewed economic slowdown, so they are contemplating rate cuts. But here's the wrinkle: Lower short-term rates sometimes trigger higher long-term rates because investors believe that a stimulus to economic activity will produce inflation (thus higher interest rates) down the road.

It is impossible, however, to predict the movement of interest rates. All we can say for sure is that rates today are extremely low -- the lowest in 30 to 40 years.

Still, bonds entice. Since 1970, an investment in five-year bonds has declined in value in only two calendar years (by "decline," I mean that the bond's accumulated interest payments did not exceed the fall in its price). By contrast, despite the boom of the 1980s and '90s, stocks fell in seven of the 32 years covered (the S&P's dividends did not exceed stock-price declines).

There's no doubt that, in individual years, bonds are far more stable than stocks. But over longer periods, the difference between the two assets narrows. According to Ibbotson Associates, since 1926, the worst 20 years for stocks (1929-48) produced a total return of 85 percent. The worst years for long-term bonds (1950-69) produced a total return of just 15 percent. The best 20 years for stocks (1980-99) produced a return of 2,592 percent; the best 20 years for bonds, a return of 864 percent.

By the way, when do you think those record-breaking 20 years for bonds occurred?

Right now -- the period that began in 1982.

You can see this in the performance of bond mutual funds. For example, if you had bought shares of Vanguard Long-Term U.S. Treasury fund (symbol: VUSTX) three years ago, you could have sold them last week for a profit of 38 percent. During the same period, Oppenheimer International Bond Fund (OIBAX), which owns bonds issued by governments outside the United States (lately including Russia, Austria, Peru and Britain), returned an annual average of 9.5 percent. It's up 11.2 percent so far this year.

A more diversified fund, Pimco Total Return (PTTRX), managed by the brilliant William Gross, whose mandate is to find the best bonds anywhere in the world, returned 12 percent in 2000, then 9.5 percent in 2001 and 5.6 percent so far this year -- all at lower risk levels than the Vanguard fund because Gross chooses bonds that mature sooner. His portfolio includes debt issued by Fannie Mae, the mortgage finance firm with implicit U.S. government backing; the Federal Republic of Germany; and Swedbank of Sweden.

A share in the fund has been trading around $10.50 since 1996, and investors have been receiving 59 to 69 cents in interest during each of the past six years, plus occasional capital gains. Pimco charges only about 4 cents a share in expenses, so it is no wonder that Gross has built the fund into a behemoth -- from $1.5 billion in assets in 1991 to $38 billion today. "Those looking for a core bond portfolio won't find many more-appealing choices," writes an analyst for Morningstar, the research firm.

But here is the point: We are in a roaring bull market for bonds.

Sound familiar? One reason investors may be so excited about bonds is that they are zooming in price, much as stocks were during their own bull market only a few years ago. That could be a warning -- but, then again, there are reasons to believe that the bond bull will continue to run, though perhaps at a slower pace.

Capital markets have grown more liquid -- there's more money sloshing around -- and central banks are doing a much better job maintaining productively low interest rates. Governments have learned that, with lax monetary policy and deficit spending, inflation can get out of hand. As the world economy picks up, bond rates will almost certainly rise, but perhaps not by a lot.

Still, even with their bull-market performance over the past 20 years, intermediate-term Treasury bonds have returned an annual average of 5.36 percent less than the S&P; long-term Treasurys, 3.15 percent less; and long-term corporate bonds, 3.11 percent less. Ibbotson's research shows that, after inflation, Treasurys (both intermediate and long) have returned an average of just 2.2 percent a year; corporates, 2.7 percent; stocks, 7.6 percent.

So what's the rationale for bonds for the long run?

They balance a portfolio. Bonds have a low correlation with stocks; their returns often move in different directions. As a recent report by Bernstein Investment Research and Management in New York put it: "As the classic diversifier with stocks, bonds have historically tended to perform well when stocks fall. In the eight bear stock markets of the past 30 years, bonds always made money, and sometimes lots of it." Bonds, the report goes on, "hedge your assets against the volatility of stocks and the fluctuations in the economy. And their yield can provide a steady earnings stream."

T. Rowe Price, the Baltimore mutual fund house, recently measured the results over the past 30 years of a portfolio with a mix of 80 percent stocks and 20 percent intermediate Treasurys against an all-stock portfolio that mimicked the S&P 500. The two portfolios returned precisely the same, an annual average of 12.2 percent. But the stock-plus-bonds portfolio was 22 percent less volatile, or risky.

What kind of bonds to buy? I lean toward Treasurys -- or, for investors in high tax brackets, highly rated or insured municipals. (You can compare munis with Treasurys by dividing the muni yield as a decimal by 1 minus your tax bracket as a decimal; thus, a muni yielding 4 percent for someone in a 38 percent bracket would be equivalent to a taxable bond yielding 6.45 percent.) It is difficult for small investors to assess the creditworthiness of individual corporate issues, and, historically, corporate returns have beaten Treasurys by only half a percentage point annually. Still, good managers can make profitable choices for you in both corporate and non-U.S. bond funds.

Robert C. Carlson, who chairs the Fairfax County employees' retirement system and writes an excellent newsletter called Retirement Watch (800-552-1152), recently recommended these funds: American Century International Bond (BEGBX) and T. Rowe Price International Bond (RPIBX), which are each up 15 percent so far in 2002; Dodge & Cox Income (DODIX), one of my own all-time favorites, a diversified bond fund with below-average risk and, recently, high returns; Vanguard Intermediate Corporate Bond (VFICX), with expenses of just 0.21 percent; and Columbia High Yield (CMHYX), which owns riskier corporates.

No, buying bonds for the long run is not a completely wacky idea. But do it for the right reason -- not out of panic but out of a conviction that you can build a lower-risk portfolio with a dose of debt for balance.

A version of this article first appeared in the Washington Post.

 

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