Fri 28 Jul 2006
Conventional wisdom has it that bonds are the safe haven investment and that they are the alternative to stocks. When stocks are drifting downward, the logical place to put your money is into bonds. Your biggest investment decision is to decide how much asset allocation to put into bonds versus stocks.
Unfortunately, this conventional wisdom came to prominence in the last 20 years which happens to coincide with a rather large bull market in bonds.
Unfortunately, bonds have started to turn around. If you look at the price performance of bonds over the last year (or really, since the peak back in June of 2003), the prices have been down across the board. The 30 year, 20 year, 10 year, and inflation adjusted bonds are all in a downtrend. The only bond index/etf available that is in an uptrend is SHY which focuses on 1-3 year bonds. (I like StockCharts for this because their charts include the dividends provided by the funds — look at the charts on BigCharts and you’ll see an even more pronounced downtrend, even in SHY.)
Let’s look at the case for bonds in terms of risk and reward. The reward is that you have a pre-defined constant stream of dividends, potential capital appreciation, and high safety (the potential for default is lower as long as we’re not talking about junk bonds). The risks are that there might be capital losses, inflation is greater than the dividend stream, and opportunity cost. The biggest risk, in my opinion, is that inflation outstrips the dividends consequently causing capital losses.
If the world economy begins to slow, there could be a flight to safety (bond buying) that would help the price of bonds. Inflation could also magically come under control, and foreign buying of treasuries could continue to increase forever… But I wouldn’t count on anything more than a 3 to 6 month rally. The TLT ETF had an 11% drawdown from peak to trough in the last 52 weeks (that’s with dividends included, without dividends it would have been a 14% drawdown). Can bonds rally enough to make up for the potential drawdowns?
Since most investors buy bonds via a fund, they don’t have the fail-safe of allowing a bond to mature and reclaiming their original principal. Bond funds are marked to market, which means once the price goes down, you’ve lost the money.
Incidentally, even TIPs don’t provide the safe haven that they should. TIP yields are tied to the official CPI numbers as released by the government, which means you’re at the mercy of the reporting anomolies for your yield.
The argument for bonds is shaky, and it shouldn’t be the default answer for “not stocks”. I know many people (myself included) have their hands tied when it comes to investment options in the 401(k)s… complain to your retirement account administrator to get more options. (I’ll write a separate post on what categories I think should be included in asset allocation besides stocks and bonds. The short answer: cash, gold, commodities, international bonds, international stocks, real estate/REITs, timber, etc.)
I have a large chunk of my own money in “not stocks” (a.k.a. bonds) but I have chosen the lesser of the evils available to me. I choose stable value funds where available, or money markets and CDs when necessary. I actually prefer money market funds over bond funds right now. You get very close to the same yield (if not a better yield), less risk of capital loss, and less volatility.
Right now just about everything looks shaky (bonds, stocks, commodities, gold, etc.) and if you don’t have to be in the market, I’d recommend standing aside in cash (a money market fund). My guess is that we will be able to buy almost all assets at lower prices within the next year or sooner.
I guess you have to ask yourself… are you trying to earn an above average return on your investments or are you just trying to put it somewhere as a store of value over time. If the latter, bonds and the S&P 500 are decent ways not to lose too much money. If you’re trying to earn an above average return, bonds are not my vehicle of choice.
The “problem with bonds” that I speak of applies to those who want an above average return. If your timeframe is long and your expectations are low, you probably can get a positive return out of bonds. If you believe in relative performance, bonds may do better than stocks (a.k.a., they may lose less than stocks).
Hey, if there was an easy answer, everyone would be retired, right?
[Note: Stable Value Funds are typically only available in 401(k) plans, so take advantage of them there if you have the option. They typically have higher yields than CDs and equally low volatility.]
July 28th, 2006 at 11:23 pm
Bonds tend to trade around a fairly constant price range (one of their appeals) and this makes sense since they have a predicatable face value if carried to term. Obviously day-to-day fluctuations cause the value to drift up or down, but rarely “crash” or “boom”. While ideally I’d purchase bonds directly (and I just might), for practical purposes I’m moving into the available bond funds that I can choose from within my tax-advantaged accounts.
My bond position is largely in a Total bond fund. We can discuss the efficacy of that option, but it’s sufficient for my needs and purposes.
I’m actually VERY encouraged that Bonds have been in a protracted downtrend, both because that’s to be expected in a climate of rising rates and the downtrend is well “within bounds” for the value of the bonds. Step the charts back to a 3 year view or greater and you’ll see that bond values are actually approaching the low end of their normal range–great time to buy!
I’m stepping up my bond position because:
A. I’ve made quite nice returns with my 95% equity position over the past 3 years and I don’t see that continuing;
B. I think bonds are looking very attractive now of all the available options I can easily trade in my accounts;
C. I think my move to push my position up from 5% bonds to 9% bonds in the middle of this week to be a cautious initial move out of equities and into bonds–nothing extreme, just an initial step.
My goal is to up my bond position a little here, a little there over the next few months until it approaches 15% or higher, depending on how things look.
I’m not changing my contributions, only my current investments. Thus, this is my way of rebalancing after 3 strong years of performance in the US and Foreign equity markets and REIT market. I’ll continue to rebalance until I think my investments have tipped enough into bonds to satisfy my goals.
My investment timeframe is long, but my emphasis on bonds will be shortlived (<1yr) and market driven.
To me, bonds look good on several levels.
July 28th, 2006 at 11:59 pm
It’s very hard to find a long-term chart of bonds to try and see the big picture… otherwise I would have included a graph in my original post.
The best I could find is this chart of the 30 Year Bond Yield which goes back to 1978. Since bond prices and yields are inversely related, flip the graph vertically to see an estimation of what bond prices would look like.
The current (last 3 years) downtrend is a long way from the bottom of the range.
July 29th, 2006 at 1:24 am
How funny, Jason. This was the chart of the day: http://www.chartoftheday.com/20060728.htm
July 29th, 2006 at 8:47 am
Question: with the stock market poised for a sharp correction in the near future, where will the money run to? Where does money typically run when folks get scared away from equities? Has anyone encountered a study that looks at the situation from the following perspective:
In the 3 months prior to the stock run up, average monetary inflow into equities was $________; in the 3 months after the start of the stock decline, the average monetary inflow into equities had fallen to $________. Average inflow into bonds was $________ in the 3 months prior to the equities run up, and then changed to $________ in the 3 months after the start of the stock decline. Etc. etc. for each of the major “safe havens” investments that people flock to during market down-turns, including savings accounts and money markets. Does this information exist?
Not to be overly simplistic, but much of the investing public is and I think that when stocks shift dramatically downward bond prices will be positively affected (and the yield curve will be more horribly distorted).
July 29th, 2006 at 11:21 am
One problem is we’re not dealing with a fixed amount of money invested in equities. There are a lot of hedge funds who have bought stocks, indexes, and ETFs with leverage.
If they just decide to un-leverage some of their equity holdings, they may choose not to lever up into something else (like bonds). In that event, you’d see the money multiplier effect working in reverse — causing money to effectively disappear into thin air.
There is supposedly USD$1 trillion under management at hedge funds… with leverage, that could be $3-$4 trillion.
July 31st, 2006 at 12:20 am
John,
Try this: http://www.ustreas.gov/tic/ticsec.html
It shows what foreign investor money flow looks like in stocks and bonds. Could provide you with a basis for your model questions.