Own Bonds? It's Your Choice, but Know the Facts, Including Why the Three Decades Long "Safe" and Successful Approach Has Ended

Bonds have long been considered a "safer" investment than stocks. Personally, I've never believed the "safety" was worth the lower return on investment, so I've pretty much stayed away from owning bonds over the years.


Except for a period when inflation is high and headed down or at least not higher, bonds won't provide nearly the same return as an investment in stocks. Today interest rates are at historic lows and headed higher over the next several years. Thus, it's definitely not a "safe" or good time to be a bond buyer.


How You Can Survive a New Era in the Bond Market summarizes the current situation and outlook:


"For investors, last year's losses in the bond market should serve as a wake-up call that the era of big bond-market returns is over. For the foreseeable future, many say meager returns and occasional losses will be the norm.

With the Federal Reserve having pushed interest rates to record-low levels to boost the economy, bond-market math means returns for the next five to 10 years should be in the low single digits at best, market pros say.

That doesn't mean investors should abandon bonds. That's especially the case for those, such as retirees, who need to protect their portfolios against significant price swings.

                                          

But for many investors, particularly those with very long time horizons, it may call for notching down the level of U.S. government bonds in favor of higher-returning investments, including conservative stocks, even if that means greater short-term ups and downs in a portfolio.

Worst Loss in 19 Years

Last year, the Barclays                                                           Your Value Your Change Short position                        U.S. Aggregate Bond Index, the most commonly used benchmark for the bond market, lost 2.1%. That marked its first decline since 1999 and the worst performance since 1994.

"2013 is a taste of what we may be seeing the next couple of years," says Shawn Rubin, a financial adviser at Morgan Stanley.                       MS in Your Value Your Change Short position

The problem is essentially that interest rates had been pushed so low by the Fed that there is nowhere to go but up. Bond prices and yields move in the opposite direction.

This marks a sea-change for bond investors who have enjoyed a bull market going back more than three decades.

From 1981 through 2012, the Barclays Aggregate index posted an average annual total return of 8.9% a year. During that time, stocks in the S&P 500 index returned 12% including dividends. More recently, from 2000 through 2012, bonds returned 6.3% while stocks returned 3.5%.

How bad will things be from here? A rule of thumb is that investors can estimate future returns based on current bond yields.

                      

                        

Wesley Phoa, an economist and portfolio manager for American Funds, does the math using the U.S. Treasury 30-year bond yield, which is currently just south of 4%.

If bond yields continue rising toward a long-run average of 4.5% or 5% in coming years, as the economy continues to recover, that would mean losses on 30-year bond prices of some 15%, he says.

With that paper loss on the bonds offsetting the slim payouts from the bonds, "you might get a 3% [total] return for long-term Treasurys," Mr. Phoa says. "You are going to earn substantially less than on stocks."

Vanguard Group has an even more muted forecast, predicting broad bond-market returns in the 1.5% to 3% a year range, says Joe Davis, head of the firm's investment strategy group. For investors whose financial plan calls for earning 5% or 6% on bond returns through a conservative portfolio, "that's going to be almost mathematically impossible.""

Summing Up

To be forewarned is to be forearmed. And it's always better to know than not know.

We've been warning about the likelihood of bonds not being a good investment for a couple of years now, and the situation won't be improving anytime soon.  Not for another decade or more.

The bond party's over, sports fans, so I suggest taking a look at owning a diversified group of relatively high yield blue chip dividend paying stocks as a bond substitute in your long term portfolio.

And some of the blue chip "defensive names" I'm suggesting may surprise you. They include stocks like Procter & Gamble, Coke, Exxon, Merck, Pfizer, GE, Intel, Microsoft, Cisco, Apple, JP Morgan, Wells Fargo and US Bank. There are many others that make sense as 'long term bond subs' as well.

The shares of these companies should provide both a stream of higher cash dividends and higher share prices over the years ahead. So for long term investors, it's worth taking a long look.

In any event, nothing stays the same forever and the three decade long declining interest rate game is over for bonds --- and perhaps in a big way too.

That's my take.

Thanks. Bob.