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The Equities/Bond Balance In Perspective -- Follow Up

by: Roger Nusbaum October 19, 2006    

Roger Nusbaum

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Roger Nusbaum submits: My post yesterday about bonds drew a few good comments and questions and merits a follow up.

There was one comment about whether to go with annuities to some degree. Annuities can be expensive, inefficient, and have a few other flaws. But they do give peace of mind, at least to the people I know that have them. In making your own decision about this you need to weigh the expense and the other issues vs. the security that goes with them. This is a subjective thing, and I can't say that someone else is right or wrong regardless of what they decide.

George plainly spells out something important that I alluded to: A bond, regardless of its maturity date, can only return its par value at maturity (TIPS and convertibles noted). A plain vanilla bond has no possibility of growth. Your expenses are guaranteed to grow. Based on how markets work the vast majority of the time, the growth from the stock market outpaces inflation. This point has nothing to do with individual tolerances, time horizon, or market timing -- this is simply about mechanics.

Things like individual tolerances, time horizon and market timing go into how portfolios are allocated. Most clients have fixed income exposure, and that is unlikely to change, but the long-term drawbacks to bonds, IMO, far outweigh the long term drawbacks of equities.

One reader asks what the best way to have exposure to the fixed income market. I don't think there is a best way. There are different parts of the bond market, and, as it is with equities, if your portfolio is large enough you should have diversification in your bond portfolio. Most segments have a couple of different ways to invest; individual issues, and funds. In most segments of the market the liquidity for individual issues will be very unfavorable especially if you need to sell. Treasuries, which have a place, don't really have liquidity issues.

For clients I own individual issues for treasuries, preferred stocks and muni bonds. I use funds for foreign, convertibles, high yield, and I use the iShares Lehman TIPS Bond (TIP) ETF.

The same reader also asks: "So what if rates are going up and the principal is going down, because one is still collecting coupon interest and the ladder distributes depreciation."

As an example: If you buy a ten-year treasury today your yield will be 4.76%. If, over the next two years, the curve normalizes, and the then current ten-year yield goes to 6.75%, well within the range of normal, you can expect the price of your treasury to fall by about 16% (a general rule-of-thumb is that a bond's price will fall 8% for every 1% rise in interest rates). So you are down 16%, and your yield is substantially less than prevailing rates. This certainly is not the end-of-the-world, but it is far from ideal, and if you had to sell for some reason, you'd be in a bit of a bind.

One point about stock dividends that was also alluded to is that they grow. 30 years ago the S&P was around 100 and yielded about 2% (a little more than today). With the S&P 500 now at 1365 it yields 1.7%. The index is up 13-fold, and dividends kept up with 85% of the market's growth (round numbers here).

None of this mitigates the risks or volatility of equities, and there is nothing wrong with yield and predictability either, but you need to know the pluses and minuses of stocks and bonds. Stocks can lose value, and bonds don't grow.

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This article has 1 comment:

  •  
    Oct 19 03:57 PM
    The issue you fail to address is average returns do not pay monthly bills. For a retired person living on investgments you need bonds for bill payment and stocks for inflation protection. As for annuities these are best left for very special situations; the average investor has no need of them.
    David
    Reply
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