Two Views on Asset Allocation

This is a very difficult time for investors to figure out how to position their portfolios.

Low interest rates are the main culprit. Throughout most of my 30 year career, bonds offered a safe, albeit boring, alternative to riskier asset classes.

You weren't going to get rich buying bonds, but you could be assured of steady returns and principal stability, which obviously appeals to many people.

But no longer.

In the wake of the latest eurozone crisis, Treasury bond yields have once again moved sharply lower. Two year Treasury notes now offer a unappealing 0.38% yield to investors, which is about half of the yield of a year ago. Even 10-year Treasurys are now yielding 2.92% at this writing.

Most high quality corporate and municipal bond yields have moved sharply lower as well.

In my opinion, with rates so low, it is hard to make a strong investment case for bonds for all but the most gloomy investor. Bonds can still play an important role in asset allocation, but with the full recognition that their primary role is principal protection, not total return.

I say this for a couple of reasons.

First, today's rates offer little inflation protection. True, there seems to be little signs of inflationary pressures today, but who knows how long this will last?

Second, if rates tick up only modestly from today's levels, the total return (price change + coupon) from a bond portfolio will turn negative. Of course, this will not matter if you are not planning to sell a bond prior - but will you really be happy looking at your portfolio of bonds that are priced below cost for the next few years?

We had a spirited discussion yesterday at our Investment Policy Committee here at the bank about asset allocation. As you might expect, there was a wide range of opinions.

Several people disagreed with me. They point to recent economic data as a sign of slowdown in the U.S. economy; in such an environment, high quality bonds should proper.

Bond bulls also point to the problems in the eurozone. If the Greek contagion spreads, the euro block could be threatened. In addition, the financial sector will be hit hard, since they are large holders of bonds denominated in euros. Dollar-denominated assets should prosper in such a scenario.

I understand all of that, but I still think that the odds favor dividend-paying stocks.

So, too, does Bill Gross of Pimco. Here's a excerpt from a recent article, along with the link:

Pacific Investment Management Co. (Pimco) managing director Bill Gross is perhaps the nation’s foremost bond guy, but he says investors looking for real returns should turn to consistent dividend-paying stocks like Coca-Cola, Johnson & Johnson or electric utilities rather than U.S. Treasuries.

In remarks made during Wednesday’s opening session of the Morningstar investment conference in Chicago, Gross echoed themes he recently wrote in his monthly investment commentary for Pimco, the Newport Beach, Calif.-based money manager with $1.3 trillion in assets

Specifically, he noted the Federal Reserve has kept interest rates lower than they should be in hopes of inflating the economy and boosting riskier asset classes, such as stocks. That’s been a boon for the latter but hasn’t translated into success for the former. Meanwhile, much of the Treasury yield curve wallows in negative territory compared with expected future inflation.

That means Treasury investors “are getting their pockets picked,” Gross told the audience.

http://www.fa-mag.com/fa-news/7643-gross-pitches-dividend-stocks.html