Friday, December 7, 2012

Why Bonds Are Riskier Investments Than Stocks

The conventional wisdom is that stocks are risky and that bonds are safe. "Everybody knows that."

We also were taught that homes were a great investment. "Everybody used to know that," but now we know better.

But what about the conventional wisdom of bonds being preferable to stocks? Is it true? No, it isn't.

So let's take a few minutes here and explain why investing in bonds is in fact riskier than owning stocks generally, as well as why it's a much more risky approach currently.

But before we begin, let's be clear about one thing. We're talking about investments and not quick trades. I don't engage in short term trading and don't recommend it for others either.

So let's return to the relative merits of investing in bonds or stocks, and why investing in bonds makes no sense either now or anytime soon.

When rates increase, the value of bonds declines. The lower the beginning point of the interest rate level from which the rate increase begins, the worse will be the loss on the value of bonds owned. Today's interest rates are at historically low levels. Over time rates definitely will increase. As a result, bond values will decline. It's just math.

The aforesaid increase or decrease in the principal vlaue of the bond is then added to or subtracted from the interest rate paid on the bond, aka the coupon rate, to arrive at the total return or loss of the investment, as the case may be. Thus, if the loss on the principal value of the bond exceeds the interest rate on that bond, the individual will suffer a loss on his investment, interest income included. And if the interest rate paid is lower than the inflation rate, the real inflation adjusted loss will be even greater than the nominal loss.

The point is simple. Do not invest in bonds in a period of rising interest rates.

Danger Lurks Inside the Bond Boom clearly lays out today's investing alternatives of bonds compared to blue chip stocks:

"Investors have been flocking to buy bonds issued by top-rated companies, putting them on pace for a record year of debt raising in the U.S. But some of the biggest fund managers warn that dangers are lurking in what were once seen as the safest investments.

Amid the rush of bond deals, which already have topped $1 trillion in value, these managers . . . are pointing to unusual wrinkles suggesting that now could be one of the most dangerous times in decades to lend to investment-grade companies.

Interest rates are so low and bond prices so high, they warn, that there is little room left for gains. Some worry that even a small increase in interest rates—a traditional enemy of bond returns—could eat away at bond prices.

For the first time in decades, some companies are offering a dividend yield—the value of annual dividend payments divided by the share price—that is higher than the interest rate they pay on their bonds, meaning that investors could get a better stream of income from stocks....

"Fixed-income is becoming an asset class with more risk to it, and I think people underestimate that," said Rick Rieder, who oversees more than $600 billion in assets as BlackRock's chief investment officer of fundamental fixed income. . . . "It would take very little in the way of a rate increase for investors to lose their total returns across many traditional fixed income sectors.". . .

The average double-A rated bond, the second-best grade given by credit-rating firms, yields 1.96%, compared with the average dividend of 2.33% for companies in the Standard & Poor's 500-stock index, according to Goldman Sachs Group Inc. Wal-Mart Stores for instance, now pays a 2.22% dividend on its stock, up from 2.17% two years ago. Its bond maturing in 2020 yields 1.875%, from 4% two years ago. . . . bonds were viewed as a sweet spot for many investors because they were considered less risky than stocks but also offered higher yields than U.S. Treasury bonds. That drove prices up and yields down.

But the massive rally, which saw the average yield of an investment-grade corporate bond fall to 2.66% from 4.04%, means there is now little cushion should interest rates rise. As rates rise, the value of existing bonds with lower yields declines.

Yields are so low companies often borrow below the 2.2% inflation rate, meaning bondholders are losing money in real terms. . . .

Bond math dictates that losses will be magnified when interest rates are low, and when bond maturities are long, as they are now. The average corporate bond sold in 2012 matured in more than 11 years, up from less than eight years in 2009, according to Dealogic.

According to Barclays data, if interest rates rose by just one percentage point, the average bond issued in 2012 would lose 5.12% of its value.

By contrast, the same scenario in 2007, when rates were higher and maturities shorter, would have caused a 1.82% decline.

And even if rates don't rise, the chances of a continued rally are slim, some skeptics say.

To generate capital appreciation, prices have to keep climbing, pushing yields lower. With average yields so low, another 10% annual return—the median average over the past three decades—would be "mathematically impossible" unless medium-term Treasury yields—the benchmark for corporate debt—fall to zero, according to Bank of America Merrill Lynch credit strategist Hans Mikkelson.

Some analysts and investors argue that interest rates are likely to remain low for some time. The Fed is still buying Treasury and mortgage bonds, keeping rates low, and has said it will keep overnight interest rates near zero through at least 2014. . . .

"We haven't seen this situation where corporate bonds are out-yielded by their equities since the early 1970s," (an investment manager) said. "As long as your time horizon is long enough and you can absorb some of the volatility, we think you have a better chance of preserving principal on the equity side.""

Summing Up

There's a time for everything. For individual investors seeking long term returns, the time for investing in bonds has ended for at least the next decade.

The time for owning dividend paying blue chip stocks over the next decade or so is here.

And the reasoning underlying this invest in stocks over bonds approach is simple.

The dividend yield on stocks is higher today than interest rates on bonds. That happens very infrequently.

The value of bonds will decline as interest rates rise over time. And over time interest rates will increase.

The value of stocks will increase as earnings rise over time. And as earnings rise, dividends will be increased as well.

Unless a company is going broke, a long term investment in that company's stock will outperform an investment in its bonds every time. And as individuals we should never lend MOM to a company or buy shares of its stock unless it is a financially sound company with a good track record, a healthy financial condition, a solid industry position and a positive outlook.

Personally, I intend to continue to invest in blue chip, dividend paying (and dividend increasing) stocks and to stay away from owning bonds.

Thanks. Bob.

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