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Compelling Evidence that Bonds are Better than Common Stock

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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

12 Comments – Post Your Own

#1) On March 29, 2009 at 2:20 PM, CAPSnGAIN (< 20) wrote:

There's two things that come to mind that might skew the data in favour of your argument.  First over the last 30 years, interest rates have been in trending down, as governments targeted low inflation.  I doubt this trend can happen much longer, with government interest rates now lower than the long term inflation targets of central banks.  Second, two major market crashes (internet bubble of 2000, and recent financial crisis), have kept stock returns unusually low.  With the exception of perhaps gov bonds and some gold stocks, I can't find any major sectors obviously still in "bubble mode", suggesting that the underperformance of stocks may not continue.

That said, I've recently been buying longer term, higher yield corporate bonds of investment grade simply because for the first time in many many years, the yields seem to more than offset the risk (which wasn't true 2-4 years ago).  Although I expect some capital gains on these bonds when the economy recovers, I don't expect them to outperform quality stocks.

 

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#2) On March 29, 2009 at 2:45 PM, eddietheinvestor (< 20) wrote:

Deej, I agree with you.  I keep reading in money magazines and in letters/brochures from mutual fund companies that stock investors must stay the course and not sell their mutual funds or individual stocks because traditionally and historically, stocks have always beaten bonds.  For instance, stocks have beaten bonds from 1935-present or 1982-present.  The only way to ensure that you could do better with stocks than bonds it to build a time machine and return to one of these aforementioned periods to invest in stocks.  I believe that people who invest in stocks, bonds, cash, and commodities only do well when they look forward by anticipating the future, not when they look back to the past.  Case in point, a lousy investor--me!  I have made the same mistake several times.  When deciding what mutual fund to buy, I see one that has made 9% annually over the past five years and another that has made only 1% annually over the past five years.  Naturally, I choose to invest in the former one because it has a much better history.  Who wouldn't choose the one that returns 9% over the one that has returned 1%?  So I invest in the one with better historical returns, and the fund tanks, while the one I decided to avoid because of the lousy returns suddenly gets hot.  I keep making the same mistake because I look at the past rather than thinking of market conditions that can cause the future results to change.  Similarly, the fact that stocks have historically done better than bonds is no guarantee for future returns, particularly under current conditions.

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#3) On March 29, 2009 at 3:24 PM, BradAllenton (31.39) wrote:

The problem is what is "Investment Grade" The ratings on the debt can't be trusted. The scratch my back, I'll scratch yours relationships between the companies and the ratings agencies are dishonest. Look at all the debt that was rated AAA that has blown up over the past few years. I like the idea of a nice return that seems safe, but I don't trust the ratings one bit. If people go for this type of strategy, be very cafeful.

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#4) On March 29, 2009 at 3:25 PM, JibJabs (89.58) wrote:

"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."

I'm going to go read the article because I love Maudlin's column too, but I just wanted to note that his figures were skewed in favor of bonds, as he admits. Roubini's 401k is all stock (his private capital is in cash) because he claims equities have the best returns historically (I'm merely deferring to an economist).

One other item of interest: this is a study that found that economists are significantly more likely than any other educated group to hold equities (it does not, however, contrast equities to bonds).

The money line is this: "The result [of the study] is astonishingly clear; a formal education in economics implies that the probability of participating in the stock market is higher than for any other educational background."

Food for thought. 

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#5) On March 29, 2009 at 7:46 PM, AnomaLee (28.60) wrote:

BradAllenton
"I like the idea of a nice return that seems safe, but I don't trust the ratings one bit. If people go for this type of strategy, be very cafeful."

It's your money not Fitch or Moody's. I used them as a guide in my search, but I wouldn't be investing in any company[stocks or bonds] where I was unable to personally research their financial condition. 

Deej
Since you touched on the issue of liquidity: Do you advocate any funds or do you favor direct purchases?

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#6) On March 29, 2009 at 9:50 PM, TMFDeej (99.41) wrote:

I completely agree with your thoughts on the ratings agencies, Anoma.  I barely pay attention to what they say.  do your own research.

I'm not a big fan of bond funds.  I just don't like the fees and black box aspect to them.  I personally purchase individual bond issues on my own with the intention of holding them to maturity.  It's actually pretty easy to do.  I suppose that I wouldn't be opposed to buying a fund from PIMCO or someone else who was really smart, but I prefer to buy individual bonds on my own.

Deej

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#7) On March 29, 2009 at 11:44 PM, BradAllenton (31.39) wrote:

"I used them as a guide in my search, but I wouldn't be investing in any company[stocks or bonds] where I was unable to personally research their financial condition". 

What part of the research do they list the fraud under? I have gone over many a balance sheet and have never found the page where it tells the truth. I would go out on a limb and say that most of the debt out there is B.S.  You can never get your hands on the "REAL" data. That's why D.D. and funnymentals are a joke.

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#8) On March 30, 2009 at 6:34 AM, TMFDeej (99.41) wrote:

Hi Brad.  I pay very little attention to what ratings agencies say about companies.  Sure, there are some financials that have all sorts of obscure derivative bets on the books, but the vast majority of public companies have transparent balance sheets that list how much debt they have and when it is scheduled to mature.

Much like I would never purchase stock in a company without researching it on my own just because a service recommended it, I would never buy a bond just because Moody's or S&P said to.  The problem with bonds is that investors got too lazy and raather than doing their own research they blindly trusted the shady ratings agencies.  I would never ever buy a stock just because say Schwab gave it a solid equity rating and I would never buy a bond just because a company has a good credit rating.

People need to take care of themselves and do their own research, not buy things just because someone else said that it was safe to do so.

Deej

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#9) On March 30, 2009 at 6:07 PM, BradAllenton (31.39) wrote:

Hey Deej, trust me I agree with the idea and understand the concept, but every person I know who has ever kept the books on a large company has told me that you can't trust one line of what they put out. They are very creative. An extreme example would be Enron. The balance sheet looked great, but it was all fraud. I know it isn't as pervasive as some may think, but it is out there and a guy like you or I have no real way of knowing who is who.

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#10) On April 01, 2009 at 1:12 AM, sandrick (83.53) wrote:

ok...you're really right.  By accident, I bought "a" JPM bonds and the Delaware Muni Az bond "a" and it now looks like I did it on purpose - I began the year at 60/40 stock/bonds.  But I moved to 50/50 as the year began and only lost $79,000 or 15% or so.  While the market lost what! 

So why do I really feel pretty good...bonds that's why.

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#11) On April 01, 2009 at 1:13 AM, sandrick (83.53) wrote:

ok...you're really right.  By accident, I bought "a" JPM bonds and the Delaware Muni Az bond "a" and it now looks like I did it on purpose - I began the year at 60/40 stock/bonds.  But I moved to 50/50 as the year began and only lost $79,000 or 15% or so.  While the market lost what! 

So why do I really feel pretty good...bonds that's why.

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#12) On April 01, 2009 at 1:19 AM, sandrick (83.53) wrote:

ok...you're really right.  By accident, I bought "a" JPM bonds and the Delaware Muni Az bond "a" and it now looks like I did it on purpose - I began the year at 60/40 stock/bonds.  But I moved to 50/50 as the year began and only lost $79,000 or 15% or so.  While the market lost what...

So why do I really feel pretty good...bonds that's why.

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