Compelling Evidence that Bonds are Better than Common Stock
March 29, 2009
– Comments (12)
Bonds are better than common stock. They're cheap right now and they are safer. I have been beating this drum for a while now. Putting my money where my mouth is, I have converted the vast majority of my personal investment portfolio and retirement funds into individual corporate bond issues. Sure, I still have a few dividend paying common stocks floating around, but for the most part any new money that I invest is going into bonds.
Interestingly, I have come across a number of articles on how bonds are better a better investment than common stock recently. I'm not sure if it is because I am looking for articles on this subject more closely, sort of like you never notice a certain model of car until you buy one and then you see them all over the place, or if people have been writing more on the subject lately.
I came across two fantastic pieces on the subject of bonds this weekend. The first is an excerpt from Michael Santoli's article in this week's Barron's. He says that corporate bonds are a great buy right now:
...once again (nominally) high-grade corporate bonds are looking rather attractive by several measures.
J.P. Morgan Chase credit analyst Eric Beinstein last week noted that the high-grade bond benchmark is pricing in "a default rate of about 45%" over the next 10 years - and 10 years is the average life of bonds in the index. He says this means a hypothetical investor could buy the components of the index, funding the purchase at the London Interbank Offered Rate, watch 45% of the bonds go bust, then recover only 20% of face value, and still break even for the decade.
The worst 10-year default rate for high-grade debt since 1980, he says, was 5%, implying the market is building truly cataclysmic credit losses, in part because liquidity in this market remain so scarce.
This is an extended way of illustrating that - outside the ultra-high-quality slice of the market - corporate debt now should reward prudent risk-taking.
That is what I have been saying. Why on Earth would I buy stocks and pray that the capital gains gods enable me to time the market so that I can squeeze an 8% to 10% gain out of them when I can buy corporate bonds and lock in 8% to 10% returns at the top of the capital structure all day long right now?
John Mauldin also recently wrote a piece extolling the virtues ofbonds in his fantastic weekly newsletter. In it he cited a new paper titled "Bonds: Why Bother?" by Rob Arnott, Chairman of Research Affiliates. In the piece, Arnott debunks the myth that all investors have repeatedly beaten into their head by the financial media and investment advisors, that stocks consistently outpace bonds over extended period of time so they are worth the additional risk of investing low on the capital ladder. Here's what Mauldin has to say on the subject:
If you do not think stocks will outperform bonds by some reasonable margin, then you should invest in bonds. That "reasonable margin" is called the risk premium, about which there is some considerable and heated debate.
Most people would consider 40 years to be the "long run." So, it is rather disconcerting, or shocking as Rob puts it, to find that not only have stocks not outperformed bonds for the last 40 plus years, but there has actually been a small negative risk premium...
How bad is it? Starting at any time from 1980 up to 2008, an investor in 20-year treasuries, rolling them over every year, beats the S&P 500 through January 2009! Even worse, going back 40 years to 1969, the 20-year bond investors still win, although by a marginal amount. And that is with a very bad bond market in the '70s.
And this is just investing in lousy U.S. government debt which I would never, ever do. I am suggesting investing in senior corporate bonds that are scheduled to mature much sooner than 20 years. Most of the issues that I own mature in less than 7 years and they have yields to maturity that are three to four times Treasuries (8% to 10%)
Mauldin continues:
Let's go back to the really long run. Starting in 1802, we find that stocks have beat bonds by about 2.5%, which, compounding over two centuries, is a huge differential. But there were some periods just like the recent past where stocks did in fact not beat bonds.
Look at the following chart. It shows the cumulative relative performance of stocks over bonds for the last 207 years. What it shows is that early in the 19th century there was a period of 68 years where bonds outperformed stocks, another similar 20-year period corresponding with the Great Depression, and then the recent episode of 1968-2009.
In fact, note that stocks only marginally beat bonds for over 90 years in the 19th century. (Remember, this is not a graph of stock returns, but of how well stocks did or did not do against bonds. A chart of actual stock returns looks much, much better.
img src="http://farm4.static.flickr.com/3641/3394762033_0e4f7e2a60.jpg">
Bill Bernstein notes that in the last century, from 1901-2000, stocks rose 9.89% before inflation and 6.45% after. Bonds paid an average of 4.85% but only 1.57% after inflation, giving a real yield difference of almost 5%. In the 19th century the real (inflation-adjusted) difference between stocks and bonds was only about 1.5%.
In the late '90s, stock bulls would point out that there was no 30-year period where stocks did not beat bonds in the 20th century. The 19th century for them was meaningless, as the stock market then was small, and we were now in a modern world.
But what we had was a stock market bubble, just like in 1929, which convinced people of the superiority of stocks. And then we had the crash. Also, from 1932 to 2000 stocks beat bonds rather handily, again convincing investors that stocks were almost riskless compared to bonds. But in the aftermath of the bubble, yields on stocks dropped to 1%, compared to 6% in bonds. If you assumed that investors wanted a 5% risk premium, then that means they were expecting to get a compound 10% going forward from stocks. Instead, they have seen their long-term stock portfolios collapse anywhere from 40-70%, depending on which index you use.
So what is the actual risk premium? Rob Arnott and Peter Bernstein wrote a paper in 2002 about that very point. Their conclusion was that the risk premium seems to be 2.5%. Arnott writes:
"My point in exploring this extended stock market history is to demonstrate that the widely accepted notion of a reliable 5% equity risk premium is a myth. Over this full 207-year span, the average stock market yield and the average bond yield have been nearly identical. The 2.5 percentage point difference in returns had two sources: inflation averaging 1.5 percent trimmed the real returns available on bonds, while real earnings and dividend growth averaging 1.0 percent boosted the real returns on stocks. Today, the yields are again nearly identical. Does that mean that we should expect history's 2.5 percentage point excess return or the five percent premium that most investors expect?
"As Peter Bernstein and I suggested in 2002, it's hard to construct a scenario which delivers a five percent risk premium for stocks, relative to Treasury bonds, except from the troughs of a deep depression, unless we make some rather aggressive assumptions. This remains true to this day."
I could go on and on about why I feel that select corporate bond issues are much better investments than common stock right now, but I'm headed to the movies with my little ones. Talk to you all tomorrow.
Deej
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