How Bond Investors Can Avoid Becoming Losers
The 10-year Treasury has recently been yielding between 1.5% and 2%. Short-term Treasury interest rates are near zero. Even if inflation stays at 2% over the next decade (the informal target of the Federal Reserve), government bonds will provide negative real (after inflation) rates of return.
And if interest rates rise to more normalized levels, bond investors will suffer substantial capital losses. Interest rates are also low in the center of Europe as well as in Japan. There are no “safe” economies where savers are able to earn positive real returns on government bonds.
Most developed countries are burdened with excessive debt. Governments around the world are having great difficulty reining in spending. The easier course of action as seen by politicians is to hold down interest rates to artificially low levels and hope that over time inflation will erode the real value of the debt.
This process, known as “financial repression,” is a not-so-subtle form of debt restructuring — and bond holders will be the sure losers.
We have seen this movie before in the United States. After World War II, the debt-to-GDP ratio in the U.S. peaked at 122% in 1946, even higher than today’s ratio of about 100% The policy response then was to keep interest rates pegged at the low wartime levels for several years and then to allow them to rise only gradually beginning in the 1950s. Moderate-to-high inflation did reduce the debt/GDP ratio to 33% in 1980, but this was achieved at the expense of the bondholder.
The last time interest rates were this low was during the 1940s. Bond investors suffered a double whammy during the 1950s and later. Not only were interest rates artificially low at the start of the period, but bondholders suffered capital losses when interest rates were allowed to rise.
As a result, bondholders received nominal rates of return that were barely positive over the period and real returns (after inflation) that were significantly negative. We are likely to be entering a similar period today.
So what are investors — including those investors in retirement who seek steady income — to do?
There are two reasonable strategies that investors should consider. First, look for bonds with moderate credit risk where spreads over Treasury yields are generous. The second is to consider substituting a portfolio of dividend-paying blue chip stocks whose dividends have grown over time.
Many countries (including the fast-growing emerging markets) have low debt/GDP ratios, younger populations and excellent growth prospects. Many of these developing economies issue bonds with good credit quality and attractive yields.
On the other hand, aging populations in the U.S., Europe and Japan are likely to lead to deteriorating fiscal situations.
In addition, taxable investors should consider a portfolio of tax-exempt municipal bonds. The fiscal problems of state and local governments are well-known, and the parlous state of municipal budgets has led to relatively high yield spreads on all tax-exempt bonds. Many revenue bonds with stable and growing sources of revenue sell at quite attractive yields relative to U.S. Treasuries.
Another asset class that should be considered as an income-yielding bond substitute is a diversified portfolio of dividend-growth stocks with attractive yields.
Many excellent companies have dividend yields that compare very favorably with the bonds issued by the same company.
An example is AT&T. The company’s common stock has a dividend yield of almost 5%, about double the yield on AT&T 10-year bonds. Moreover, the dividend from AT&T has grown at a 5% rate since 1985. While the growth rate of the dividend may moderate over the years ahead, it is difficult to imagine that investors won’t be better off with the stock (and stocks of similar dividend-growth equities) than they will be from bonds in the same companies.
And if interest rates normalize, the volatility of a bond portfolio may be no less than the volatility of a dividend-growth portfolio.
We are very likely to have entered an era that will be inhospitable for investors in many high-quality bonds in the world’s developed economies. Fortunately, some reasonable alternative strategies exist for income-seeking investors. The traditional diversification advice of a simple stock-bond mix needs to be fine tuned.
Burton Malkiel is author of “A Random Walk Down Wall Street” and serves on the Investment Advisory Board of retirement-advice firm Rebalance.