Thinking About Buying Government Bonds? Think Again

 |  Includes: AGG, BND, BOND
by: StreetAuthority

by David Sterman

The late 1970s were an absolutely brutal time for investors. Stagflation ruled the roost as inflation spiraled out of control and economic growth remained anemic. Yet, investors wise enough to load up on bonds made an absolute killing. Double-digit yields were easy to find and investors who held these bonds into the next decade or two saw strong gains (as bond yields steadily fell).

In fact, the era of falling bond yields continued up until today. Each time we thought bonds couldn't go any lower, they dropped more. Take a look at what has happened to 10-year U.S. Treasuries during the past two decades.

Watching the 10-year Treasury reach yields of just 1.7% is a moment few of us thought we'd ever see. As I'll explain in a moment, this low yield is unlikely to last. One thing's for sure: it is almost impossible for yields to drop even lower. With such paltry yields in place and little hope for rising bond prices (which happens when yields fall lower), this is the absolute worst time to be buying more government bonds. (And it's a great time to sell any bond funds that have recently appreciated sharply in value).

But many are doing the opposite by shunning stocks and loading up on bonds. Retail investors have pulled an estimated $12.5 billion out of stocks and mutual funds thus far in the third-quarter, while they have poured $25 billion into bonds, according to the Investment Company Institute (ICI).

The economic disconnect
To understand why bonds are now a lousy investment, you need to look at why bond yields are plunging. Historically, bond yields have been nothing more than a hedge against inflation. Investors bought them with a promise of getting a slightly better return than the rate of inflation -- a modest compensation for taking on the very minor risk of bond default. In fact, you can track bond yields during the past 75 years, and they have a remarkable correlation with inflation rates. But in the past four years, that link has been broken. After the Great Recession of 2008, bond yields dropped toward the rate of inflation, and at some point in 2011, these yields actually fell below the rate of inflation.

That's because investors stopped buying bonds as a way to hedge against inflation, but instead sought out bonds simply because no other attractive investments existed. For the thousands of investors who have been too uncomfortable to own stocks in this uncertain economy, bonds have been the favored alternative. The problem is that it's increasingly looking like a very bad decision.

The inflation hedge is gone
As noted, for the first time in my life, the 10-year Treasury bonds yield is now below the rate of inflation. This means you'll lose money buying these bonds (on an inflation-adjusted basis) with the losses rising higher as the years unfold, thanks to the effect of inflation. As of now, the 10-year bond yields about 1.65%, while just-released producer price data shows inflation rose 0.3% in July (ahead of forecasts of 0.2%). That's just a snapshot in time, but extrapolates out to an annual inflation rate above 2%.

Inflation concerns have been put on the backburner in recent years, but it's notable that the capacity utilization index -- a key measure of inflationary pressures -- is approaching a reading of 80, which has historically signaled an inflection point for supply chain bottlenecks and rising prices.

Let's assume inflation pressures don't quickly emerge and instead settle into a range of 2.3% inflation. If you buy a 10-year $10,000 bond now, then you would have $11,778 in a decade. But $10,000 in today's dollars will inflate to $12,553, which means you could lose roughly $800 if the bond is redeemed in 2022 after inflation.

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This assumes inflation remains dormant throughout the period. But when the economy finally mends, inflation is likely to move back to the historical 3% to 4% range we saw in the past few decades. Let's assume inflation stays dormant until 2014, at which time it rises to 3.5%. By that math, you've lost roughly $2,000 on the bond investment.

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Yield vs. yield
An argument against bonds is also an argument for stocks. Simply put, average yield paid out by a typical company in the S&P 500 now exceeds the yield on the 10-year bond. I went into this topic in great detail back in June.

In addition to today's superior yields, stocks are proven to be a better investment than bonds over the long haul. The recent rally in bond prices is setting up a clear contrast., "In terms of relative performance, current bond prices in relation to stocks remain abnormally high from a historical perspective, levels which have traditionally been a precursor for significant stock outperformance," noted analysts at the Bank of Montreal.

They back that up with facts. The BMO analysts noted that bonds handily beat stocks in 1977, 1982, 1985, 1987, 1990, 2002 and 2009. But those were great times to pivot out of bonds and back into stocks. "Interestingly, each of these periods were followed by a prolonged period of stock outperformance (e.g., two years or greater). From our perspective, stocks are on the verge of repeating this cycle yet again given recent trends," said BMO in a recent note to clients.

Risks to Consider: As a near-term upside risk for bonds, if the European crisis erupts into full-fledged chaos, then a "flight to quality" could (temporarily) push bind yields even lower.

While I focused on the relative appeal of stocks in my column cited earlier, this column is a clear, unvarnished call on why you should avoid fresh U.S. government bond purchases. Don't like stocks? Look to other assets such as real estate, corporate bonds, foreign government bonds (that still have appealing yields), collectibles and any other items that have a history of keeping up with inflation.

I still think stocks are the way to go. I'm actually fairly bearish for the market in coming weeks and months simply because the market seems to have gotten ahead of itself. The S&P 500 is already up 10% this year and almost 20% in the past 12 months, despite numerous near-term headwinds.

But with an eye on the long-term, stocks are indeed shaping up to represent deep value. More to the point, they are a superior hedge against inflation. You really should only consider bonds again when the 10-year yield exceeds 3.5%, which should be perceived as the long-term rate of inflation.

Disclosure: David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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