The Case For 0% Bond Allocation

Includes: COP, CVX, LMT, MO, PM
by: Tim McAleenan Jr.

Earlier this year, Warren Buffett called bonds "terrible investments" stating:

"In some future] days, they will sell at a yield a whole lot more than right now…The question is always when, and I'm no good at that. But you will have interest rates much higher than they are at some point in the future-that's not a game I can play telling you when, other than a reasonable period…I don't like owning bonds now."

When pushed about the conventional wisdom that you should always have "something in bonds", like 30-50% once you reach a certain age, Buffett said:

"No, you shouldn't be 40% in bonds. Bear in mind, I deal with people who have the proper attitude and if stocks go down 20%, they're not going to be bothered. I tell them to have enough cash on hand so they are comfortable, and put the rest into stocks. I think it's silly to have some ratio like 30%, 40%, or 50% in bonds. They are terrible investments now. Oh, it's now. I bought bonds back in the '80s and made a lot of money, I bought them personally, but price determines attractiveness."

And the terms have not changed much since Buffett's comments. On November 1st, 2013, the ten-year Treasury rate came in at 2.65%, and the thirty-year rate came in at 3.69%.

Those terms are terrible, considering that you can buy high-quality dividend stocks that offer a higher current yield than that right now. Conoco (NYSE:COP) would you give you 3.78% at current prices, Altria (NYSE:MO) would give you 5.14%, Lockheed Martin (NYSE:LMT) gives you 3.95%, and Philip Morris International (NYSE:PM) will give you 4.19%. Each of those companies currently pay you more than the thirty-year Treasury, plus they retain earnings so that profits will increase going forward, and the amount of the dividends that you receive will continue to grow whereas the bond payments remain static-it's just a sustained monotony of the same payment while inflation chews away the value of the bond payments. All the dividend stocks I mentioned have to do is increase the dividend greater than 4% annually to make you richer over the passage of time (unless we have 1970s style hyperinflation).

Interestingly, I reached the conclusion that bonds were unnecessary to buy right now by following the teachings of Benjamin Graham. I say "interestingly" because Graham was known for counseling the 25/75 to 75/25 range with portfolio allocation. Namely, he said that you should generally find yourself between a 25% bond/75% stock allocation and a 75% bond/25% stock allocation, regardless of market conditions.

I reject that advice because I choose to follow something else that Benjamin Graham regularly counseled investors to ask themselves when contemplating any investment, "On what terms and at what price?" If inflation is going to be between 3.5-4% annually, it doesn't make sense to lock into a 2.65% bond or a 3.69% bond when it is easy to capture starting dividend yields higher than that amount that have a reasonable likelihood of growing every year into the future.

The only advantage that bonds offer over stocks in general is nominal stability-you keep getting that 2.65% or 3.69% "locked in" yield year after year. But when you look at what Charlie Munger, Donald Yacktman, Benjamin Graham, and Walter Schloss taught us, you will see that they instruct us to think in terms of purchasing power rather than nominal dollars. All four of those men regularly cited to Irving Fisher's book titled "The Money Illusion" which stated that the surest way to grow poor is to think in terms of total dollar amounts rather than increases in purchasing power.

Fisher quoted from many German working-class (errr, he used the term Arbeiterklasse) families that felt they were getting richer by getting raises of 7% when the prevailing national inflation rate was 10%. No, they were getting poorer because they could buy fewer total goods than before. I think it would be very difficult to read the book "The Money Illusion" and then turn around and make a substantial long-term commitment to US Treasury bonds. When you lock in at a 2.65% or 3.69% yield, you are not only giving up growth in the name of stability. You, are in fact, willingly becoming poorer by reducing your total purchasing power in exchange for the perceived bond safety.

Right now, Chevron (NYSE:CVX) has a 3.39% dividend yield. For every share of Chevron you buy, you get $4.00 in annual dividends. But here is where it gets fun-Chevron is currently making $12.24 in total annual profits. The dividend only takes up one-third of Chevron's profits. The other two-thirds' can be dedicated to stock buybacks and organic growth so that the dividend can continue to grow into the future. By the next annual dividend raise, Chevron stockholders will achieve parity with the 30 year-old bondholder. The dividend raise after that, and the Chevron investor will surpass the thirty-year Treasury bondholder. And, over the course of the next thirty years, the dividend difference between someone owning Chevron stock and someone owning a thirty-year Treasury will become staggering because that dividend growth will compound upon itself while the Treasury payouts remain static.

If Treasury bonds were yielding 6-7% right now and the inflation rate were half that, the conversation would be different, because the terms of the investment would be different. But right now, you are faced with a 2.65% or 3.69% static yield, depending on the duration you choose. That's why it is borderline investment malpractice to recommend long-term bond funds right now-they have no chance of matching the overall performance of a prudently selected basket of stocks over the long-term. Unless we enter a period of deflation or very low inflation, there is no way that a portfolio of Treasury bonds purchased today does not decrease your purchasing power and effectively make you poorer over the long term.

Disclosure: I am long COP. 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.