Thursday, August 22, 2013

When Will Bonds Become Competitive to Stocks?


  FRED Graph

One of the major drivers of the stock market rally over the past two years has  been the low level of bond rates. 

Most strategists - including the author of Random Glenings - have consistently made the argument that high quality bond yields were too low to be attractive for investors with longer time horizons.

Since the lows of October 2011, the S&P 500 has climbed +42%. Not coincidentally, high quality bond yields generally fell during the same period.

As the chart above shows, Treasury yields fell from 3% in mid-2011 to 1.5% by the middle of 2012. As recently as this past April, high quality bond rates were around 1.7% for maturities of 10 years or less.



However, since that time, bond yields have started to reverse course, and now are almost back to where they were in the summer of 2011: 10 year Treasury notes now yield almost 3%. 

 

Municipal bond yields are also hovering around 3%, which on a tax-equivalent basis translates into almost 5%.

At some point, bonds will again be competitive with stocks, particularly to risk-adverse investors.

Before you scoff at 3% bond yields as being sufficient compensation for investors, consider the following  proposal that the state of California is developing as an alternative to traditional investment plans for retirees.

From the Guardian:

Kevin de Leon thinks it should be different. He's the California state legislator who took on the financial services sector by promoting what is now called the California Secure Choice Retirement Savings Program, shepherding it through the legislative process and getting Governor Jerry Brown's approval last fall. He's now in the beginning stages of realizing the plan.

De Leon's initiative would automatically deduct 3% for retirement savings from workers' pay at firms with at least five employees and no 401k already in place. The money would be pooled and managed in a newly established entity. Participants would get a 3% return, which is very modest. An insurance policy would underwrite the plan, so taxpayers would not be financially liable if the plan loses money. At retirement, the account balance will be turned into an annuity.

http://www.theguardian.com/money/us-money-blog/2013/aug/15/do-it-yourself-retirement-alternative

If you have a tax-deferred portfolio such as an IRA, you can purchase a zero coupon Treasury obligation today at nearly 3%, or a price of 74.25.  This means that $100,000 today will be guaranteed to be worth nearly $135,000 in 2023.

This is essence is identical to what California is proposing, except that it is backed by the full faith and credit of the United States government.

True, this is probably less than stocks will offer over the next 10 years.  Then again, for someone that doesn't want to worry, a guaranteed +35% return for the next 10 years might seem pretty appealing.

I don't know when bonds start to become competitive to stocks again, but at a time when revenue growth remains sluggish, and corporate managers cautious, I think we need to be mindful of the message from the bond market.