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Bonds: Return-Free Risk (15 Feb 2012)

There are so many comments to intriguing SA article "Asset Allocation For A Dividend Growth Investor" by David Van Knapp see seekingalpha.com/article/349011-asset-al... that I cannot afford to read because have not enough time.
I also commented to the article and because I used figures my comment is in blogpost - see seekingalpha.com/instablog/725729-sds-se...-2012

I'd like to add one more comment and again I need figures to illustrate my point, so it is here

Basically David Van Knapp said in the article that his pension + social security payment is a substitute for bonds. The author claimed that he can avoid bonds with dividend growth stocks and deal quite well with inflation. This is quite unusual statement. If we look just on US dividend stocks and US government long-term bonds in last 30 years we find that bonds are better shield from inflation than stocks for income investor (fig.1)


FIG. 1: data from American Association of Individual Investors - Download Library, Historical Market Data.

So assuming /of course wrongly/ that i) all interest can be reinvested tax-free without any fees, ii) the bond is hold ONLY till inflation smaller than yield, iii) the bond is sold without loss of principal, we can congratulate such bondholder with win against inflation and perfect timing.

But between 1946 and 1981 sometimes inflation in USA was stronger than long-term bonds' yield but such periods were quite short.
On another hand correlation between stocks and bond prices is weak.
Therefore many market pundits propose a mix of bonds and stocks for investors with age-dependend receipy for the mix. Usually the pundits recommend increase bonds part with age claiming that they are less risky than stocks. Moreover, "risk-free return" is the standard description of government's bonds. Indeed it was no single default of US government's bonds, but even long-term (10 years) US bonds do not protect income investor from inflation in case of not-so-frequent (once in 5 years) tactical rebalance of this asset class as I conclude from fig. 2 below.

FIG. 2: data from Brandes Institute/Ibbotson Associates for 10 years US government's bonds

I think more often e.g. quarterly rebalance leads to worse result for investors (but better fees for investor advisers) but as James Montier said "rather than simply asserting that something is true, I would like people to show me the evidence that this really is the case".

I think that US economy and geopolitical situation were unique in last 100+ years. If we look in old well developed economies in Europe we find quite different picture. For example, German government bonds became worthless two times in XX century; UK had periods of inflation and deflation (fig.3)


FIG. 3. UK data

As James Grant said (see www.ft.com/intl/cms/s/0/bd69356a-c229-11...) government bonds might be "return-free risk" (!)

Fortunately US did not face hyperinflation during quite short country history but IMO post-2008 monetary policy in US and Europe plus islamic terrorism plus strange US/China relations might lead to economic collapse and default of US goverment bonds.

And the last but not the least today's comment to the "Asset Allocation For A Dividend Growth Investor" article:

David Van Knapp said in the article that HIS pension + social security payment is a substitute for bonds. I'll probably have no pension and default of social security and goverment bonds might be strongly correlated in time. I hope we will NOT see such defaults in USA as UK had during their longer history.

Added 2 Jan 2014:

Well there is no sense to invest in bonds now as graph below shows:

But, should I invest in bonds in the future? Probably not. Ronald H. Muhlenkamp was politically correct and didn't mentioned government bonds when he wrote the following:

"In the bond market the borrower issues the bonds and therefore writes the rules. Consequently, bonds are designed to make money for the borrower, not for the lender."

Although I doubt that government creates the rules to panish holder of Threasures, I keep in mind that government can print money and therefore create inflation higher than any interest rate on their bonds. So only MUNI might be worth to consider for hight tax bracket investors. But often municipals loan money for period they choose, which might be not perfect for a lender. BTW government can make the same with loan period via ratio between bonds issues with different maturities.

Again Mr. Muhlenkamp citation "Corporate stocks provide higher returns than corporate bonds because management works for the stockholder and against the bondholder" confirms my preference for equity, and esp. for dividend growth (NYSE:DG) and high yield (NYSE:HY) stocks.