Nearly all of us have heard it said that bonds are safer than stocks. The basis for this observation is that bond prices have often been less volatile than stock prices. Does this mean that bonds are a good bet for an investor who wants to preserve capital?
Whether an investment is sound depends importantly on the price paid. Bonds have provided a good return since the early 1980s. However, prices are now extremely high, and we are very concerned that bonds may drop significantly in value in the near future. Should this happen, the very people now buying bonds for safety will suffer big losses.
What makes us concerned?
We’re worried for quite a few reasons. Consider:
- The prevailing “wisdom” is that investors should own more bonds as they get older. Consultants often use a rule of thumb that says an investor’s portfolio should have an allocation to bonds that corresponds to his or her age. A 60-year old would have 60% in bonds, a 70-year old would have 70%, and the rest of the portfolio would be put in stocks. The problem with this advice is that it ignores the prices being paid. If bond prices were twice as high, would the consultants recommend the same allocation?
- Investors already have more invested in bond-like investments than they realize. Social Security benefits, after all, can be thought of as a bond. An average 65-year old couple who begin taking benefit payments this year will receive $2,176 per month; an average widow or widower $1,274.¹ Using a 20-year life expectancy and a 3.5% discount rate, those amounts equate to a present value of $375,000 and $220,000, respectively. That can be a sizeable chunk of an overall portfolio.
- Interest rates are at very low levels. For example, today’s (8/4/15) 30-year fixed mortgage rate of around 4.25% almost looks like a misprint to those of us who obtained mortgages during the past 20 to 40 years. And as I write this article, the yield on a 10-year US Treasury Bond is 2.18%–well below the 6.42% average rate from the beginning of 1962 to today. Rates would have to more than double just to get back to this average.
- Monetary and fiscal pressures may lead to inflation in the near future. Central banks across the globe are promoting extraordinarily easy money in an effort to stimulate their economies and fund large budget deficits. Higher inflation will lead to higher interest rates as lenders try to preserve their real purchasing power.
- As a rule, bond prices fall when interest rates rise. Because investors will demand an increased return on their money, they will not offer as high a price to buy existing bonds. For example, if the rate on the 10-year US Treasury bond climbed from today’s 2.19% to 4.19%, the price of the bond would fall over 16%. Bonds with longer maturities would fall more. If the rate on a 30-year Treasury bond were to increase from today’s 2.88% to 4.88%, the price of the bond would fall 31%. In either case, the piddling amount of interest received on these bonds will not offset the dramatic losses.
- Those who are “reaching for yield” will fare even worse. Many bond buyers are unimpressed with the low yields being paid by issuers with strong credit ratings. This has led some to buy higher-yielding bonds from less credit-worthy issuers. Such purchases may prove to be disastrous. The less credit-worthy borrowers are the very ones that will find it hard to re-finance or pay off their debts when borrowing conditions are not so favorable. Those who lent money to these issuers may experience credit losses on top of the losses attributable to a general rise in interest rates.
We’re not the only ones who are worried.
Investors we admire are saying many of the same things. For example, Warren Buffett recently said (5/4/2015) that “bonds are very overvalued” and that not only would he not recommend owning these, but also that “If I had an easy way, and a non-risk way, of shorting a whole lot of 20- or 30-year bonds, I’d do it.”²
What do we recommend?
It’s only prudent to own securities when they offer reasonable rates of return. These securities can include shares of stock in attractively-priced companies that generate excess cash flow. Companies that generate excess cash can reward shareholders by investing for growth, buying back shares at inexpensive prices, and paying dividends. When bonds are priced fairly, they also can be rewarding. However, right now is an extraordinarily bad time to own them. We’d rather stick with the stocks of our companies.
For those clients worried about fluctuations in stock prices, we’d like to remind them that we believe stock prices will, indeed, fluctuate. We would not be surprised to see a market “correction” in the near future. However, we also have estimates of what we believe the companies we buy for our clients are worth, and we are not inclined to sell shares of these simply because their prices drop. In fact, to the extent that our clients have available cash in their portfolios, we may very well decide to buy more at attractive prices. This explains why we currently hold 13% to 14% in cash in many of our clients’ portfolios.
It is important for an investor to have “staying power” through market downturns. To put it succinctly, you should have cash available for living expenses and a reasonably optimistic long term outlook on the economy. To the extent that you lack either of these, we suggest that instead of buying bonds, you hold more cash in order to reduce overall portfolio volatility.
Eric Ball, CFA®
Chief Executive Officer
America First Investment Advisors, LLC
¹ Social Security Administration Factsheet – www.ssa.gov/news/press/factsheets/colafacts2015.html
² Business Insider – www.businessinsider.com/buffett-i-think-that-bonds-are-very-overvalued-2015-5#ixzz3hrvbN9qf
This post expresses the views of the author as of the date of publication. America First Investment Advisors has no obligation to update the information in it. Be aware that past performance is no indication of future performance, and that wherever there is the potential for profit there is also the possibility of loss.