Sunday, September 4

Week 9 - Bonds

Situation: Stock prices reflect earnings expectations but are also influenced by market forces (“a rising tide lifts all boats”). Bond prices reflect the of risk of bankruptcy but are also influenced by market forces (the prospect of inflation or deflation). When a company declares bankruptcy, it’s stock price falls to zero but it’s bond price falls by only 20-30% since bondholders stand to benefit from the sale of assets. Accordingly, investment-grade corporate bonds are only 20-25% as risky as is the parent company’s stock.

Goal: To convince our readers than a 50% asset allocation to bonds is a reasonable and appropriate hedge against unsettling fluctuations in their stock holdings.

Over long time periods, annualized total returns for the S&P 500 Index exceed inflation by 4-7% vs. 2-3% for investment-grade bond indices. Studies comparing bond and stock indices back to 1802 show that  bonds outperform stocks 29% of time in rolling 10-yr periods. <click here for a related story in Smartmoney> We are currently ending a 20-yr period in which bonds have out-performed stocks. This is an extremely rare “Black Swan” event.

This week we are adding an investment-grade bond fund managed by T. Rowe Price (New Income Fund - PRCIX) to the ITR Table of Lifeboat Stocks from Week 8. This table compares the 18.5 yr total returns of 5 Lifeboat Stocks to SPY, and to inflation. Returns for PRCIX exceed those for SPY but are less than those for Lifeboat Stocks. While PRCIX is not an index fund, it’s performance closely tracks the benchmark bond index: Barclays Capital U.S. Aggregate Index. While stocks in general have performed poorly due to back-to-back recessions, bonds (and Lifeboat Stocks) are somewhat immune and keep returning value that beats inflation.

A simple way to demonstrate how bonds can stabilize an investment portfolio is to compare SPY to US Savings Bonds. Over the 12.25 yr period that ended August 26, 2011, a one-time $500 investment in SPY (on 1/29/93) grew to $549.37 using dividend reinvestment (0.77%/yr). In contrast, a $500 investment in an inflation-protected US Savings Bond grew to $1014.20 (5.94%/yr). Adding the two together shows that $1000 grew to $1563.57 (3.72%/yr), which still beats inflation of 2.53%/yr by 1.19%.

At first glance, this appears to be a skewed example because the investment in SPY was made on 6/1/99 when the stock market was clearly overvalued (the “” bubble was in full flower). People were enthusiastic about buying stocks but unenthusiastic about buying bonds, particularly those with inflation protection, since the government was paying down its debt and no one believed inflation was a threat. The US Treasury had to offer unusually high interest rates to entice investors to purchase its inflation-protected offerings.

Now if we compare this to the opposite case, an investment in SPY when investors were avoiding stocks (after a recession that had cost them money): $500 invested in SPY on 1/29/93 grew to $1849.05 by 8/26/11 using dividend reinvestment (7.29%/yr). At the same time (1/93), a $500 investment in an EE Savings Bond (guaranteed to double in value after 20 yrs) grew to $1315.20 (5.34%/yr) over the same 18.6 year period. As expected, stocks outperformed bonds in this example because of market timing. That is, SPY was bought when it was on sale because investors preferred bonds. Add the two $500 investments together and $1000 grew to $3164.25 (6.40%/yr). The combined return again beats inflation (which was 2.50%/yr), this time by 3.9%/yr. To summarize, we have shown that even when a 50:50 investment in stocks & bonds is made under conditions that are very favorable to one but not the other, returns for the combination are stable and beat inflation over time. Thus, bonds in a portfolio act like ballast in a ship.

In the Week 3 Goldilocks Allocation blog we recommended a 50% allocation to bonds, divided as follows: 50% in an investment-grade bond fund like PRCIX, 33% in an investment-grade international bond fund like T. Rowe Price’s RPIBX (to counteract the falling dollar), and 17% in 10-yr US Treasury notes. These two no-load bond funds can be purchased over the internet like a point-and-click DRIP, using automatic electronic withdrawals from your bank account on a regular basis. Purchase of treasury notes is similar except that an order has to be placed each time through

Until recently, 10-yr Treasury Notes were considered to be the optimum risk-free investment. Then Standard & Poor’s pointed out that the US Treasury may have to restructure it’s long-term debt in the not-too-distant future. Why is that? Well, the Federal government is breaking some rules of financial prudence, i.e., running budget deficits that far exceed GDP growth, and running debts that exceed 60% of GDP. The cardinal rules for government finance were established in the Maastricht Treaty (2/7/92), which codified requirements for European countries wanting to use the Euro as currency. A country had to first demonstrate that it’s annual budget deficits did not exceed the nominal rate of GDP growth (i.e., GDP before adjusting for inflation) and that it’s government debt did not exceed 60% of GDP: A country with nominal GDP growth of as little as 3%/yr may be able pay off that degree of debt over time (Carmen M. Reinhart & Kenneth S. Rogoff, “This Time is Different; Eight Centuries of Financial Folly”, Princeton Univ. Press, Princeton, 2009). However, a debt that exceeds 90% of GDP becomes impossible for a slow-growth country to pay off without having to restructure (i.e., default). Currently, the US budget deficit is 12.7% of GDP and its debt is 99% of GDP. This is why S&P has downgraded US Treasury notes and bonds from AAA to AA+. You are probably asking for a compelling reason why you need to invest in these debt instruments! The answer is that there are advantages to holding some bonds until their principal (your original cost) is returned to you. And the only notes/bonds that are both widely-available and carry little risk are those issued by the US Treasury. For example, China recently bought $100 billion worth of US Treasury bonds and notes.

Inflation will cause a bond mutual fund to fall in value, along with the prices of the underlying bonds. This is because a newly issued bond pays more interest than an older bond (issued before inflation took off). To limit that loss, bond fund managers will trade long-dated bonds for short-dated bonds as inflation develops. If you own treasury notes, your solution is simply to wait a few years: Your original investment will be returned to your bank account and, by holding onto the note, you will continue collecting interest, helping to pay for new notes that pay more interest. The point is that there are advantages to owning individual bonds as well as bond funds.

Bottom Line: Bonds are an investor’s best friend, especially in a deflationary environment (i.e., during a recession). Even if there is rapid inflation, the loss of value in a managed bond fund is less than the loss of value in an indexed bond fund, since managers are free to shorten maturities thereby limiting losses due to long-dated bonds, whereas long-dated bonds have to be left alone in an indexed fund. Even with inflation caused by a strong economy, losses to an indexed bond fund are less than the losses incurred by an indexed stock fund at the opposite end of the economic cycle, i.e., during a recession.

<click here to move to Week 10>

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