Bond Math

You don’t need a degree in Psychology to know that investors are nervous. Pick up any newspaper, or just take your own pulse. Macro issues dominate almost every investing decision, and it’s therefore not surprising that the safety of bonds remains attractive. No doubt fixed income has had a great run. The Dow Jones Corporate Bond Index, a benchmark of long duration investment grade debt, has returned 7.9% p.a. since the beginning of the millennium. The S&P500 has managed 0.5% p.a. over the same period. Investing by looking backwards can be reassuring – generally if something has happened before, it can happen again. Bonds look better than stocks in the rear-view mirror and they can appear pretty compelling looking forward too. If the Euro collapses then for stocks, so goes the conventional wisdom, down is a long way. And so it might be. But here’s the Math. High grade bonds (as defined by the relevant iShares ETF, LQD) yield 4.4%. That is what the hold-to-maturity investor in long-term corporate debt can hope for. Factor in a 40% tax rate on interest payments with 2.5% inflation and it will be hard to maintain purchasing power. Stocks were roughly 2.5 times as volatile as bonds over the last decade – selling those bonds and putting 40% of the proceeds in large cap, dividend paying stocks that yield 3.5% (with the rest, for now, in cash) maintains the same overall portfolio volatility and only requires 3.8% dividend growth to beat bonds (compared with a fifty year growth rate of 5%). The 60% in cash provides a useful option to invest at a later date when prospects are clearer – and who knows, maybe one day interest rates with an integer could return to the money markets. Ben Bernanke is steadily raising the stakes for those bond investors who wish to invest alongside him. The Fed’s QE2 program has created a large and non-commercial buyer for debt that is not motivated by profit. Indeed, the Fed’s objective is to create an environment in which bond investors wish they owned something else. Real returns on investment grade and government debt are likely to remain negative for an extended period of time. The Fed has the ability to ensure this state of affairs persists indefinitely should they so desire. “I promise you negative real returns for many years” may not be a catchy soundbite, but if Chairman Bernanke said those words they would not require any change in monetary policy. While it’s usually good to follow the smart money, in this case it may be academic smarts rather than street smarts that are on display. The most significant long-term challenge facing investors must surely be identifying alternatives to traditional fixed income.

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