Singing The Big Bad Bond Blues

by: Serge d'Adesky

Hey, can you remember those good old days when bonds were the safest investment around?

For over 30 years, right up to the recent 2008 financial meltdown, a good bond allocation provided steady earnings and even long term capital appreciation. From 1962 to 2011, a portfolio invested in 10 year treasuries yielded an average return of 5.22%, and in corporate bonds an average of 7.24% ( Since inflation averaged 3.78% during that period (, retirees investing in bonds not only generated steady dividends, but in fact could even grow their nest eggs.

This period, often labeled the The Great Moderation, lasted so long some investors have come to think that such a situation is the norm. They have come to believe that bond investments can provide income as well as an inflation hedge.

Two recent academic studies of historical bond returns concluded that this period was a historical aberration, unlikely to be repeated. One study was conducted by the Credit Suisse Global Investments. The other, the London Equity Gilts Study, was commissioned by Barclays.

The conclusions of both were similar. They found that while long term bonds had beat short term bonds by 5.2% since 1982, they had only beaten them by 0.8% since 1900.

Barclays called the period from 1982 to 2007, an "exception", concluding "hoping bond returns will match the period since 1982 is a fantasy."

The Barclays' researchers ascribed the Great Moderation to the expansion of global trade and the rise of the emerging markets. The supply of cheap labor effectively exported lower inflation to the developed economies.

That trend is now reversing. Barclays report paints a scary picture. Wage inflation in countries like India and China is reaching dramatic levels. Meanwhile, the demand for resources by the growing middle classes of those emerging countries is pushing up the prices for goods and services, notably in industrial metals and in food. The emerging markets, once exporters of moderation, are now exporting inflation to the developed world.

To combat this inflation, the normal response of central banks would be to raise interest rates. If this happens, it will mean dramatically lower bond valuations. The impact on bond investors could be severe.

So how bad could it get? Take a look at the following chart of 10 year treasury interest rates over the last 50 years: interest rates on these treasury bonds went from a high of 16 percent to today's level of around 2 percent.

Historic Yields of 10 Year Treasury Bonds
(click to enlarge)

History of 10 Year Treasury Yields

If interest rates were to retrace just half of that value over the next decade. that would be a combined increase of 7 percent. This would mean 30 years bonds would lose 70% of their value, and 10 years bonds would lose around 50%!

Moreover, a number of economists, politicians (Paul Ryan), financiers and academics believe the inflation will be much more severe, and surpass the 7% levels of the 70's, with the corresponding interest rates in the high 'teens. (see hyperinflation discussion at the Economist).

This is not my view, but I am not entirely sanguine as to its impossibility. So even more severe drops in bond values are conceivable. Since the rise in interest rates would presumably be due to inflation, bond investors could not even take solace in their dividend payments. A 30 year treasury bond currently pays about 3.5%. If inflation is in the 5-7 percent range, that bond income would buy less goods and services each year.

The Retiree's Conundrum

An old rule of thumb many financial advisors still use when advising clients is to divide their age in years by 100. The resulting number is the percentage of bonds they should hold in their portfolio to be safe. Thus a 50 year old might hold 50%, and 80 year old 80%.

I always found this rule to be simplistic, but at least the gist of it was sensible. The older you get, the less time you have to recover from any drop in value of your portfolio. Consequently, equities -with their greater earnings potential but much higher volatility - are considered to be more appropriate for the young.

Needless to say, if we get any serious inflation over the next decade, this practice will send our soon-to-be elderly baby boomers - all 76 million of them, 40% of the population - to the doghouse.

[An important caveat here: an inflationary future is not a certain thing. Many economists believe that another Great Depression, and not inflation, is in our future. (See this summary of the writings of Harry Dent). If that is the case, bonds will in fact be exactly the place to be!] If top economists cannot agree on where the world is heading, what is the average investor facing or already in retirement supposed to do? There are no easy answers, but here are my thoughts and a potential direction for a safer portfolio:

  1. Lower your percentage of bonds, whatever your age.
    • For one thing, you're likely to live much, much longer than your parents did. That alone is one reason to increase your percentage of equities over bonds. As people live longer and live healthier in old age, and as the physical arduousness of most modern work declines, more people can and will choose to work well into their 80's and even 90's. Consequently, the attractiveness of equities over bonds rises.
  2. Replace long term bonds, with strong, dividend paying stocks with a history of income growth
    • Right now the dividends offered by many DGI (dividend income growth) companies pay dividends rivaling and surpassing the rate on long term bonds.
    • For example, let's compare the medium term bond to the stock of one of those DGI companies: Kinder Morgan Partners' (NYSE:KMP). KMP's most recent bond offering was a 10.5 year debt at a 3.45 percent coupon. Compare that to a $5.28 / share dividend yielding 6.3% at today's price of $83.45.
    • In the even of moderate to high inflation, I would argue that the bond investment is actually the riskier of the two alternatives. Why? Because of the near certainty of a loss on the bonds. At just 4% inflation the bond will have generated a total income return of around 34%, but when the bond finally matures in 10 years, its purchasing power will have dropped by 40%. For most retirees, this is a recipe for disaster.
      Granted the stock could be worth less than what you paid for it, but it could also be worth significantly more. Also, the stock would have to drop by 30% from its original buy price to make up the difference in dividend income paid out over the years.
      Take a look at the graph of KMP values over the last 30 years. At no time during any ten year cycle was the stock worth less than at the start. Of course it can happen. But in a well-chosen, carefully selected portfolio of DGI stocks that are monitored over time, any losers will be more than offset by winners.KMP (Kinder Morgan Energy) Historic Chart
      (click to enlarge)
  3. Increase your share of multinational stocks
    • Experts will differ over which country is on the rise. Today, it's China, tomorrow India, the next day Mexico. Others say the US will rise again. Who knows which is right? Why not invest in companies that have their fingers in all the pies? These are usually the multinational corporations, who are well-versed in the legal and political complexities of international commerce.
    • Look for stocks that perform well in all times, good and bad. Try to identify long-term trends. I like oil and natural gas pipelines, utilities, telecoms, and the health industry. Agriculture and food production are also good.
  4. Know your personal inflation barometer, and invest in it!
    • Think about it: we all differ in how we spend our money and in our lifestyles, so your inflation is not my inflation. Suffering poor health or chronic illness? You'll be more impacted by rising health costs than a healthy 20 year, non-married worker.
    • For example, if you drive a lot of miles in a gas guzzler, consider buying oil stocks. If gas prices go through the rook and you're spending much more on gas, at least your oil stocks are likely to rise. And if oil prices drop and your stocks perform poorly, at least you're rewarded at the pump.
  5. Increase your percentage of short term versus long term bonds (lowering their duration).
    • This will lessen the negative impact of any increase in interest rates. You may suffer some loss of yield, but this should be far less than the loss of principal from declining long term bonds. Also when they come due, you will probably be able to roll them into higher yielding short term bonds in the near future.
  6. Favor bond ladders over broad bond funds and ETFs.
    • Setting up a bond ladder involves buying a portfolio of bonds with staggered maturities. Bonds are always held to maturity, eliminating the decline in principal value due to rising interest rates prior to maturity. Steadily maturing bonds provide needed liquidity. Maturing money not needed for income is reinvested into new bonds at the longest maturity level. Since longer-term bonds usually pay higher yields, the money from mature bonds is always reinvested at the highest possible rate within the parameters of the ladder.
    • For portfolios over $200,000, use a mix of individual bonds and the new class of targeted date maturity ETFs. The ETFs provide diversification and low acquisition costs. Carefully selected individual bonds can provide superior, risk-calibrated returns, often at returns 1% to 1.5% higher.
    • For portfolios under $200,000 use target date maturity ETFs over individual bonds.
    • A specific example of a laddered bond investment can be viewed on my website.
  7. As much as possible, gamble with your earnings, not with your principal.
    • A knowledgeable deployment of derivatives or options can give you equity like returns without the risk to principal.
    • For example, take a 5 year bond - held to term - paying a 4% coupon
    • Use one-half of those earnings (2%) in carefully calibrated, diversified options strategies that limit risk to the amount invested.
      Such strategies, properly executed, can double or triple the amount invested in any year, yet never risk more than the premiums invested.
      By reinvesting any gains each year, there is good possibility of doubling your money over five to seven years without ever risking principal.
  8. Despite their name, avoid long term Treasure Inflation Protected Securities. As a recent Wall Street Journal article bluntly stated: "It is mathematically impossible now for investors to earn respectable returns from any of them, and in many cases they are a lock to lose money in real, inflation-adjusted terms."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.