Thursday, September 8, 2011

A Bond Manager Begs to Differ


A friend of mine manages bond portfolios, and she is tired of hearing me bash bonds.

"All you seem to do is focus on yield for bonds," she noted. "The total return for bonds - coupon plus capital appreciation - has been been better than stocks for last decade. I know yields are low now, but at least bonds will return your money at some point in the future."

She was only getting started.

"You keep writing that we're not turning into Japan, but what if you're wrong? The return of the Nikkei for the last 20 years has been terrible - far below Japanese bond returns, which at least have given a positive return."

"Why don't you write about that?"

My friend is right on the past returns. With the exception of the last 12 months, bond returns have been far better than stocks for the last few years. For example, through the end of August 31, 2011, the total return of the S&P 500 for the past 10 years has been +31%, while the Barclays Government/Credit Bond Index has produced a total return of +68% over the same period.

But here's my problem with the total return argument for bonds.

Namely, the indexes assume essentially a constant maturity. Most individuals buy a bond, then hold it until maturity.

Ten years ago, for example, the 10 year Treasury note was yielding 4.8%. If someone had simply bought the 10-year, they would have seen their principal value fluctuate up and down over the 10 year period, but at the end of the day their total return would have been around +48% (or probably less, since the coupon reinvestment rate during that period was less than 4.8%).

The only way an individual would have gotten the return for the Barclays Intermediate Govt/Credit would have been if they would have bought a bond fund. However, a bond mutual fund offers no guarantee of principal return, which negates at least one of my friend's arguments.

The other point I would make is this: True, bonds have outperformed stocks for the last 10 years, but what about the next ten?

Take the same 10-year note example.

The Treasury 10-year today yields around 2%. It is almost mathematically impossible for someone to buy a 10-year note today and get a total return of +68% for the next years unless reinvestment rates soar.

In addition, if interest rates tick up only modestly - say 30 basis points, to 2.3% - your total return for the next year will be negative, since the principal value will decline by more than the coupon.

So I remain unrepentant: Bonds offer stability and a (very) modest level of income, but I still think that the investment case for dividend-paying stocks for most people remains compelling.