Dreaming of Bonds

by | Mar 24, 2003

Last year, investors pulled $25 billion out of stock mutual funds and added $125 billion to bond mutual funds. You can hardly blame them. It’s scary out there, and, as war nears, it’s getting scarier. My view, as readers of this column have heard many times, is that bonds are generally for the short term […]

Last year, investors pulled $25 billion out of stock mutual funds and added $125 billion to bond mutual funds. You can hardly blame them. It’s scary out there, and, as war nears, it’s getting scarier.

My view, as readers of this column have heard many times, is that bonds are generally for the short term (five years or less) and stocks for the long term. If you are a 35-year-old investing for retirement, you may not need to own a single bond. My reading of history shows that stocks return more than three times as much as bonds after inflation, and over long periods the risk profiles of the two assets are about the same.

In fact, economist Jeremy Siegel of the University of Pennsylvania has written, “It is little known that in the long run, the risks in stocks are less than those found in bonds.” Since World War II, U.S. Treasury bonds have suffered more losing years than stocks (19 vs. 14).

Still, it makes no sense to worry yourself sick over your investments. So don’t be ashamed to admit that, as your stock portfolio has deteriorated, you have been dreaming of bonds.

Open your eyes, however, and you’ll see a big problem. Bonds don’t pay much interest these days. On Wednesday, five-year Treasurys were yielding 2.7 percent, or $270 a year on a $10,000 investment. If you’re in a 27 percent tax bracket, you’ll keep $197. If inflation is 2 percent this year, you’ll roughly break even. That’s not too exciting, but, on the other hand, you don’t risk losing $2,000 or more a year, as you might with a stock portfolio.

Low yields equal high prices. In other words, bonds today – especially Treasury bonds – are expensive. Last week, for $10,000, you could buy a bond that would pay interest of $377 a year between now and 2013. But in 1992, you could have purchased that same stream of safe income for just $5,000.

We are now riding the greatest bond bull market in modern history. Nearly every year for the past two decades, bond yields have been falling and bond prices rising. Will it continue? There’s no way to tell, but remember what happened to a similar 20-year bull run in stocks. The sudden enthusiasm of small investors for bonds today could be just as dangerous as their sudden enthusiasm for tech stocks in the late 1990s.

The main reason bond prices have increased so much since the early 1980s is that two Federal Reserve chairmen, Paul A. Volcker and Alan Greenspan, have wrung high inflation out of the U.S. economy. Lately, low rates reflect a sluggish economy, where demand for money is low, and worry about war, which leads investors to seek safety. There’s also the stock market. “Bonds are not valued in a vacuum,” writes James Grant of Grant’s Interest Rate Observer, “but in comparison to alternative opportunities. If the stock market were to rise in the wake of a short and victorious war, bond prices would probably fall.”

Interest rates on government bonds are now lower than they’ve been in 40 years. A note that matures in seven years is paying 3.3 percent interest; in two years, 1.5 percent. (A “note” is an intermediate-term bond.) Investors today are desperately seeking yield. It’s not easy to find, but I have some ideas to pass along.

Before we go further, let’s get our terms straight. When you buy a stock, you become a partner in a business, an owner. When you buy a bond, you lend money to a business or a government agency, which promises to pay you back on a specific date, with interest along the way. In other words, a bond is an IOU, and an investor is a creditor.

Bonds carry two kinds of risk.

First, there’s credit risk – the chance that the borrower won’t meet the promise to pay you timely interest or return your principal. U.S. government bonds, and the bonds of practically every industrial nation, carry infinitesimal credit risk. Don’t worry about it. Municipal bonds, issued by state and local agencies, are, in general, only a tiny bit riskier than Treasurys, but each muni has different terms and guarantees. (Interest on munis is free of federal, and often state, taxes.)

Corporate bonds also vary in risk. Bonds rated AAA (tops) by Standard & Poor’s, for example, are not supposed to be much more risky than Treasurys. Bonds rated BBB are considered the lowest-level investment-grade bonds (below that are speculative, or “junk” bonds). In 2002, the BBB default rate was 4.5 percent. Junk bonds suffered a peak default rate of 10.5 percent during the 1990-91 recession and again during the 2001 recession. In between, their default rate fell as low as 1.7 percent.

Shakier companies have to pay more interest to attract buyers. Over the past 20 years, for example, a BBB-rated bond has paid an average of about a percentage point more interest than a AAA-rated bond.

The second kind of risk is caused by inflation. If today you lend the government $10,000 for 10 years, you can be assured that you will get your $10,000 back in 2013. But you can also be assured that, in 2013, it won’t buy as much as $10,000 does today. The reason is inflation – that is, a general rise in the price of goods and services.

Since World War II, inflation, as measured by the consumer price index, has averaged 4.1 percent – which means that in 10 years it will cost $14,900 to buy what $10,000 buys today. (Another way to say this: In a decade, today’s dollar will probably be worth just 67 cents.) Lately, inflation, as measured by the consumer price index, has been pretty tame – about 2 percent annually. Even at that rate, it would take $12,190 in 2013 to buy what $10,000 buys today. And it’s doubtful that CPI growth will average just 2 percent far into the future.

When you buy a bond, the interest you are paid is supposed to make up for the losses caused by inflation (interest also compensates you for taking credit risk and for the use of your money). But, with the vast majority of bonds, there are no guarantees.

In the case of Treasury bonds, the rate is established by investors, who take a guess about how inflation looks in the future. Many times, of course, that guess is wrong. For example, at the start of 1968, inflation was 3 percent, and you could have bought a 10-year Treasury bond paying interest of 6 percent. But in 1973, inflation hit 8.8 percent. New bonds issued that year carried rates that reflected higher inflation, but what if you wanted to dump the bond you bought back in 1968 before maturity? You would have to take a big loss, selling for perhaps 60 cents on the dollar.

This is a key concept with bonds, and one that’s hard to grasp at first. If inflation expectations rise, then the rate of interest on new bonds will rise and the price of already-issued bonds will fall. Higher rates mean lower prices. Conversely, if rates fall, then prices rise. Say you bought a 30-year Treasury bond in 1985. It carried a coupon – that is, an interest rate – of 11.25 percent. The bond still has 12 years to maturity, but you could have sold it last week for 167, or $16,700 for a $10,000 bond. Lower market rates mean higher prices for bonds with high coupons.

But which bonds to buy? And how?

Begin with TIPS: Treasury Inflation-Protection Securities. They pay a guaranteed “real” rate of interest plus an inflation kicker. I have been a huge enthusiast of TIPS ever since they made their debut under Robert E. Rubin and Lawrence H. Summers in 1997. Originally, the real rate was around 3.5 percent for notes due in five years. But investors shunned them, prices fell, and rates rose above 4 percent. Now that was a bargain. A week ago, the real yield on a TIPS issue maturing in five years was just 0.75 percent. If inflation is 4 percent, then you earn 4.75 percent; if it’s 1 percent, you earn 1.75 percent.

In a recent letter to clients, Jason Rotenberg and Amit Srivastava of Bridgewater Associates Inc., one of the earliest supporters of TIPS, argued that “five-year real yields of 0.75 percent are still attractive.” And, they say, the rate will probably drop even further. Why attractive? Compare TIPS with five-year conventional bonds yielding 2.7 percent. As long as inflation is higher than 2 percent, as it has been in 16 of the past 20 years, you will do better with TIPS. And TIPS can protect you against true catastrophe: inflation rocketing to 6 percent or higher, as it has in one-third of the years since 1969.

The most recent 30-year TIPS issue, which was launched last year but which you can buy from your bank or broker on the open market, had a real yield on Wednesday of 2.4 percent. Its original coupon was 3.375 percent, so it has soared in price (up more than 20 percent) in the eight months since it came out. (By the way, you can also buy TIPS when they are issued through Treasury Direct.)

A warning about TIPS: The inflation bonus is paid on the back end; that is, it is added to the bond’s principal, so you only get the real interest rate as current income. You are, nevertheless, taxed as though you received the bonus on an annual basis, so you have to dig into your own pocket to pay Uncle Sam – unless, of course, you hold TIPS in a tax-deferred account such as an IRA.

The second approach to consider these days involves bond mutual funds – particularly funds that offer a mixture of government and corporate securities. My normal preference is for buying individual bonds and holding them to maturity; that way, you know exactly what you are getting and you don’t have to worry about fluctuations in market price. While these diversified funds are riskier, they let you reach for higher yields with the help of an expert manager. Otherwise, you’ll just have to accept returns of about 3 percent (or 2 percent after taxes) in intermediate-term Treasurys or U.S. government agency notes. The alternative – buying long-term Treasury bonds that pay about 4.8 percent – is a big gamble. If inflation increases, the value of such bonds will plummet. Who wants to hold a bond yielding less than 5 percent for the next 20 years if inflation is 6 percent? Or even 4 percent?

Consider, instead, a fund like TIAA-CREF Bond Plus (TIPBX), which just happens to be yielding 4.8 percent but whose portfolio has an average maturity of just six years. If inflation rises, then as the holdings mature the fund can roll them into new bonds paying higher rates. About two-thirds of the bonds selected by manager Lisa Black are U.S. Treasurys, the rest are corporates with ratings roughly evenly spread from BBB to AAA, including debt issued by Pharmacia, Diageo Capital and Banc of America Commercial Mortgage.

Scott Berry of Morningstar wrote last week that “we can’t say enough good things” about the fund, citing its “restrained approach” and its “low expense ratio” – just 0.3 percent. Over the past three years, the fund has produced average annual returns of 10 percent – with about half coming from price increases. Don’t expect those kinds of gains in the future. But 4.8 percent in interest alone would be just fine.

Another excellent choice is Harbor Bond (HABDX), a riskier fund with only 10 percent of its assets in governments and 36 percent in AAA-rated corporates, plus a big dose of AAs and some junk bonds. The fund has been managed since 1987 by William H. Gross, the master of diversified bond buying, and it currently yields a hefty 5.4 percent with an average maturity of seven years. Gross knows where the sweet spots in the bond market are. Like the TIAA-CREF fund, this one gets five stars from Morningstar, whose analyst says that, while Gross is aggressive and the fund has been volatile, you can’t fault his “astounding long-term record.” The fund, recommended as well by Sheldon Jacobs, editor of the No-Load Fund Investor newsletter, carries an expense ratio of just 0.6 percent.

The third attractive fund, Vanguard Intermediate-Term Bond Index (VBIIX), mixes Treasury notes and Freddie Mac bonds (which have an implied, but not explicit, government guarantee) with investment-grade corporates such as General Motors Acceptance Corp. and Citigroup and a surprisingly high dose of junk bonds. It now yields 5.5 percent, has a rock-bottom expense ratio of 0.2 percent and produced returns of 12.8 percent in 2000, 9.3 percent in 2001 and 10.9 percent in 2002.

Now, don’t you wish your stock fund had done that?

Ambassador Glassman has had a long career in media. He was host of three weekly public-affairs programs, editor-in-chief and co-owner of Roll Call, the congressional newspaper, and publisher of the Atlantic Monthly and the New Republic. For 11 years, he was both an investment and op-ed columnist for the Washington Post.

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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