Weekend thought: asset allocation strategies need to ditch bonds, seriously
A common investment strategy, used by both individuals and some of the best and most famous money managers on the planet is an asset allocation strategy where some % of assets is kept in stocks and some % of assets is kept in bonds.
This type of strategy can be helpful by instrinsically buying stocks when they are down, selling stocks when they are up, ditto bonds. You have a 50/50 allocation, the stock market crashes 40% the bond market rallies 10% and now you have 2:1 bonds to stocks, so you would re-balance, buying stocks and selling bonds. Later when equities have doubled and bonds have come back to earth you'd take some stock profits off the table and add to bonds. Fine strategy.
But, the challenge facing this strategy, and bond funds like PIMCOs are several fold:
1. Treasuries have been in an almost unprecedented 30 year bull market. Here is yield on the 10 year in a picture. 30 years of declining yield. Before that we had almost 30 years of rising yield on the 10 year.
2. Interest rates are basically at all time lows. The value of bonds is inverse to interest rates. If interest rates rise, bonds will fall (meaning the yield on the bonds rises). Its difficult to imagine that interest rates can drop significantly from here or stay here forever.
3. Money has been pouring into bonds and out of stocks. In 2009 bond funds saw 100's of billions of dollars of inflow, equity funds saw outflows (save hedge funds, which saw modest inflows).
The table is set for bonds to experience some pressure, or possibly the table is set for a new secular bear market in bonds.
And if I may add one more point, I'd like to observe that the yield on bonds right now is less than stellar. The 10 year yields 3.6%, the 30 year yields 4.5%, forget about shorter time-frame bonds, they yield nearly nothing. High quality, investment grade corporate bonds aren't all that much better than long-dated treasuries. Andlower grade corporate bonds, while offering a better yield, come with credit risk. I read on realmoney silver over at thestreet.com, in a note from the resident bond guru, that the expected default rate on junk bonds puts their expected actual yield just better than investment grade corporates.
So bonds are at or near all time highs, interest rates at or near all time lows... but the stock market remains reasonably priced, trading at levels still 30% below recent highs, and is not up in 12 years.
Therefore, at this time, I think it is emminently reasonable to consider the holding of bonds in an asset allocation strategy imprudent.
Rather, one should sub, for bonds, low beta high yielding large cap blue-chip stocks with good financial condition. I would suggest the following:
T. AT&T. Telecom/wireless provider for the ages. Big, growing, growing profits, trading at a p/e of 10, in absolutely no financial trouble and yielding 6.7%. Thats a dividend, so you pay 15% tax instead of up to 35% tax for income from other bonds (except some municipal bonds, which can be tax free on the federal level). 6.7% taxed @ 15% leaves the holder with about 5.7% take-home. If you're in the top federal tax bracket you'd be paying up to 35%, meaning that a bond would have to yield about 9% to match that. AT&T has a long history of dividend growth as well.
If you put $1,000,000 into bonds right now, at 9%, you'd make $90k a year, take home about 50-60k depending on your state and tax bracket. And in 10 years you'd still be taking home 50-60k.
If you put $1,000,000 into T right now, at 6.7% yield, you'd make $67k a year, take home about 50-57k depending on your state, but... and this is a BIG BIG BUT, 10 years ago T was paying about $1/share, right now it is paying $1.68/share. Stocks like T grow their dividend. In 10 years you'd be recieving perhaps $2.50/share, meaning thatbased on your $1mil investment now your income would be ~$100k, and you'd take home perhaps $75-80k based on todays tax rates.
STOCKS CAN GROW DIVIDENDS.
So in light of the issues with bonds and these facts about stocks
1. They are not expensive today, especially big high yielders like the ones I mention above and below
2. They can and have and will grow their dividends over time
3. The value of the shares themselves can, has, and will go up over time whereas the value of bonds over time is very unlikely to, and if held to maturity, of course, bonds are worth only par.
4. And this is the real kicker here, ... over the chaos of 2008/2009, T had LESS PRICE FLUCTUATION THAN BONDS.
It is simply prudent today to replace bonds with high yielding, reasonably valued, financially uber-stable blue-chip stocks. Make them low beta stocks just to help yourself sleep better at night. May I suggest, for your consideration
T - AT&T, as discussed above, pe of 11, forward pe of 10 (big moat in landlines, cell phones is growth)
VZ - Verizon wireless, forward pe of 10, secular growth industry (although largely mature)
BP - massive oil company, shares not up in 10 years, trading at a p/e of 10
LLY - Eli Lilly, pharmaceutical giant, yielding 5.8%, trading at pe of 9, shares not up in 14 years
BMY, GSK, AJG also make the list.
MO - Altria, cigarettes in the US
RAI, PM, other tobacco stocks may qualify
And a small part of the bond portfolio could be devoted to REITs and BDCs. I'm no REIT expert, but for BDCs I'd take a look at AINV, ARCC, FSC. Remember, these will be less stable and higher in beta than the stocks above.
But seriously, ditch the bonds, buy the blue chips. Just consider them bonds with better yield and take the dividend raises and share price appreciation as mega-extra bonus stuff.