MONEY and BANKING PAPERS LOW GRAPHICS

 


Why Invest in Bonds?


b
y Daniel Bacarella
 

 

Bonds are thought to be an investor's idea of a safe investment.  When the stock market is in trouble, investors take their money from the equity market and put it into bonds.  Also, investors feel bonds are perfect for a portfolio where they require some sort of fixed income.  A bond's coupon payment would work nicely in this case.  However, research may lead us to a different story.  Is a bond a better overall investment during these two situations listed above, and many others like them?  Peter Lynch, former fund manager at Fidelity for the Magellan Fund, and author of "Beating the Street", does not think so.  Lynch feels that no matter what the circumstance, stocks will always outperform bonds (Lynch, 15).

In the beginning of Lynch's story on stocks versus bonds, Lynch is quick to point out that (in 1993 when the book was written) 90 percent of the nation's investment dollars are not in stocks, but in bonds, certificates of deposit, or money-market accounts.  This almost makes it seem like investors are afraid of the stock market, or more so the risk associated with the market's volatility.  An example of this is the 1980s, when stocks had their second best returns overall for the decade, topped only by the 1950s.  During that time in the 1980s, the percentage of household assets invested in stocks declined and has been declining since the 1960s, from 40 percent to 25 percent in 1980 to 17 percent in 1990.  As well, investment in equity mutual funds declined from 1980 to 1990 by nearly 39 percent.  Lynch's biggest quarrel with this is the fact that major stock indexes including the Dow Jones average were quadrupling during these time periods.  (Lynch, 15)  If investors had put and kept their money in the stock market as opposed to the bond market in this example, the rewards would have surpassed what investors got from being invested in bonds by a large margin.

 

One of the main reasons that investors stay away from the stock market is that they are afraid of corrections, crashes, or bear markets.  Sure, if you are a very wise investor with tremendous foresight, it makes perfect sense to take your money out of stocks and put it into bonds right before a correction, crash, or bear market begins.  However, it also makes perfect sense to reinvest in stocks once the stock market has reached its low point in such a situation.  This is the part that many investors do not understand:  the fact that you will make the most return in the stock market right after a significant drop due to the bargains that exist.

Lynch, who obviously does not think too highly of bonds, does not really consider even pulling the money out during corrections, crashes, or bear markets.  He feels that in the long run, no matter how long something like a bear market may last, "sooner or later, a portfolio of stocks or stock mutual funds will turn out to be a lot more valuable than a portfolio of bonds or CDs or money market funds."  Here, in order to persuade his readers, Lynch provides some evidence in the form of total returns using various investment vehicles. 

 

 

Table 1 - Average Annual Return (percent)

 

1920s*

1930s

1940s

1950s

1960s

1970s

1980s

S&P 500

19.2

0.0

9.2

19.4

7.8

5.9

17.5

Small-Company Stocks

-4.5

1.4

20.7

16.9

15.5

11.5

15.8

Long-Term Gov. Bonds

5.0

4.9

3.2

-0.1

1.4

5.5

12.6

Long-Term Corp. Bonds

5.2

6.9

2.7

1.0

1.7

6.2

13.0

Treasury Bills

3.7

0.6

0.4

1.9

3.9

6.3

8.9

Inflation

-1.1

-2.0

5.4

2.2

2.5

7.4

5.1

*Base 1926-29

 

 

From Table 1, we see that only in one decade out of seven did bonds outperform stocks.  This decade was the 1930s, which was right after the stock market crash in 1929 and was one of the worst times for stocks in history.  What you can also get from this table is a look at the enormous gains that could have been made in the 1940s and 1960s.  Even if you had held bonds in the 1930s, the returns wouldn't come close to those of stocks during the '40s and '60s.  To summarize, if you invested in the S&P 500 in 1926 and held it there for the life of the table, 64 years until 1989, you would have gained 255 percent on your investment.  If you held bonds over the same period, you would have only gained 16 percent.  The percent change in inflation over this time was 19.5 percent:  3.5 percent larger than the gains you would have received by investing in bonds.  (Lynch, 16-17)

            Even with this in mind, investors are still scared by the possibility of another Stock Market Crash of 1929 type of situation.  To avoid this, some investors have missed out on all of the aforementioned gains from the stock market and have kept their money in bonds.  Their one nemesis, which some investors do not even realize is a huge problem, is inflation.  Lynch states that inflation "over time has done more damage to [an investor's] wealth than another crash would have done, had they experienced one."  (Lynch, 46)

Over the past 70 years, the annual return on stocks has been 10.3 percent, as opposed to 4.8 percent for bonds.  One main reason that stocks do outperform bonds is that owning stock means you own a part of a company.  Stocks pay dividends, and as a company grows and profitability increases, the owners of the company benefit by sharing these profits in the form of increasing dividends.  (Lynch, 49)  Corporate bondholders do not own any part of the company, and since they are on the debt portion of the balance sheet there is no sharing in new profits or any benefit from company growth.  Lynch puts it bluntly by saying “…no company in the history of finance…has rewarded its bondholders by raising the interest rate on a bond (Lynch, 50).”  Well, actually, there is an intrinsic benefit of owning a corporate bond when the company is growing, which is a lower risk of default.  However, of course, government and municipal bonds are risk-free, so unless the United States is suddenly in shambles, there is next to no risk of default on these bonds.

 

In all 316 pages of "Beating the Street", Peter Lynch takes up one half of one page to describe one short-run situation in which it is beneficial to invest all of your money in bonds.  In the first half of 1982, the stock market was doing very poorly and interest rates, inflation, and unemployment were all very high.  This was during Lynch's tenure running Magellan, and at that point long-term Treasury bonds were the fund's biggest position.  Lynch describes his only exception to the idea that owning stocks is better than owning bonds as, "When yields on long-term government bonds exceed the dividend yield of the S&P 500 by 6 percent of more, sell your stocks and buy bonds."  (Lynch, 110)  This, however, does not happen all that often.

One group responsible for the large proportion of overall investment dollars that have been sitting in bonds is the elderly.  These are people who are retired and have to live off of interest as their source of income.  Here, Lynch mentions a popular adage:  stocks for the young, bonds for the old.  However, Lynch feels that this is becoming obsolete due to the ever-increasing life expectancy.  Average life expectancy for males is 76.9 and for females is 79.5 (based on year 2000 statistics)[1].  Basically, this means an average of 15 to 20 more years of after retirement spending, bill paying, and evading inflation.  If a retired couple has $500,000 to invest and they put it into long-term bonds paying 7 percent, they will have a steady $35,000 a year income.  However, with a 5 percent inflation rate, for example, their buying power will be cut in half by inflation in 10 years and by two-thirds in 15 years.  “Except among the very rich, the good life cannot be preserved without stocks.”  (Lynch 50-51)

Lynch argues for, instead of investing retirement money in a portfolio of bonds, investing in a portfolio of stocks.  Going a step further, the retirement money could be invested in a portfolio of stocks that also pay dividends.  Dividends can provide both regular income (for the most part, unless a company ceases its dividend distribution; however, when this is the case it is common to already have dumped the stock due to poor company performance) and dividend growth, which is something that coupon payments on bonds cannot provide.  This retirement dilemma calls for another numerical analytical example.  Here, Lynch sets up Table 2, which is a portfolio of stocks that pay a combined 3 percent dividend.  This portfolio is initially worth $100,000, and you remove $7000 per year for spending.  Also, the dividend is initially 3 percent and both the dividend and the stock prices grow by 8 percent per year.

 

 

Table 2 - 100% Stocks Retirement Investment Strategy

 

Year

Beginning
-of-Year
Stocks

Dividend Income

End-
of-Year
Stocks

Spending

End of Year

 

 

1

$100,000

$3,000

$108,000

$7,000

$104,000

 

2

104,000

3,120

112,320

7,000

108,440

 

3

108,440

3,250

117,220

7,000

113,370

 

4

113,370

3,400

122,440

7,000

118,840

 

5

118,840

3,570

128,350

7,000

124,910

 

6

124,910

3,750

134,900

7,000

131,650

 

7

131,650

3,950

142,180

7,000

139,130

 

8

139,130

4,170

150,260

7,000

147,440

 

9

147,440

4,420

159,230

7,000

156,660

 

10

156,660

4,700

169,190

7,000

166,890

 

Total (1-10)

37,330

 

70,000

166,890

 

11

166,890

5,010

180,240

7,000

178,250

 

12

178,250

5,350

192,510

7,000

190,850

 

13

190,850

5,730

206,120

7,000

204,850

 

14

204,850

6,150

221,230

7,000

220,380

 

15

220,380

6,610

238,010

7,000

237,620

 

16

237,620

7,130

256,630

7,130

256,630

 

17

256,630

7,700

277,160

7,700

277,160

 

18

277,160

8,310

299,330

8,310

299,330

 

19

299,330

8,980

323,280

8,980

323,280

 

20

323,280

9,700

349,140

9,700

349,140

 

Total (11-20)

70,660

 

76,820

349,140

 

Total (1-20)

107,990

 

146,820

349,140

 

 

 

In the first year, you only get $3000 worth of income from dividends, which is not enough to cover your spending requirement.  What then happens is you sell off $4000 worth of stock.  If the stock went up by 8 percent, which it always does in this theoretical example, then you will be left with $104,000 at the beginning of year 2.  Then, in the second year, you have to sell off less stock to cover your spending requirement due to dividend growth.  The amount of stock you have to sell to cover spending marginally decreases throughout the life of the portfolio, until the 16th year when the dividend has grown to the point where you no longer have to sell off any stock to cover spending.  When all is said and done, the initial $100,000 is worth $349,140, and on top of that you have removed a total of $146,820 for spending.  (Lynch, 52, 54-55)


[1] NCHS Fastats – Life Expectancy:  http://www.cdc.gov/nchs/fastats/lifexpec.htm

This example nullifies the gripe that retired investors use to excuse themselves from investing in stocks:  they can’t afford the loss in income that bonds provide.  Not only can the 100 percent stock strategy provide the necessary yearly source of income, but also no bond portfolio has a chance of touching the returns that can be gained by a twenty-year investment in stocks.  However, this is only an example, and it made one major assumption:  stocks grow at a constant 8 percent per year.  This does not happen in the real world, as stocks are very volatile.  Many years, stocks are down.  An investor has to be patient and ride out the downs in order to reap the benefits of the ups, as well as be prepared to sell shares at depressed prices, when income is needed in a down market.  (Lynch, 55)

 

Now, to get a different view of the stocks versus bonds question, we consult various Internet articles on the subject.  The first of these articles focuses on the idea of risk preference.  This is one item that Peter Lynch did not discuss much.  If an investor does not want to take the risk that he will make a poor investment, then the investor has a pretty good argument for investing in bonds.  Lynch did mention the care an investor must take when looking into a new investment opportunity, but not all investors are quite as good as Mr. Lynch.  An investor may vigilantly look into a stock for months, but perhaps might be looking at the wrong bit of information when they think they are looking at something else, or may miss something and make a poor investment due to their lack of knowledge on investing.  The article also discusses the idea that bonds are heavily invested in at the moment, with prices of 10-year Treasury bonds at a 40-year high.  It raises the question of how much higher the prices can go, and the fact that if they cannot go up any higher, it would not make sense to keep money invested in bonds.  As well, the article states that bond experts are warning that Treasurys may not be safe investments, with the probability being small that their tremendous performance will continue.  The article then talks about the current bargains in the stock market.[1]

In an article written by Kenneth Fisher, the 21-year bond bull market is examined.  He talks about how from 1981-2002, long-term treasury rates dropped from 15.8 percent to 4 percent, and offers the idea that “if a 20-year stock run-up could lead to the last 3 years, why not ditto with bonds now?”  Fisher also sheds light on the fact that if you invest in Treasurys now, and if over the next year the yield on long-term Treasurys goes up four percentage points, then the total return would be negative 40 percent.  This is almost as much as stocks have fallen since March of 2000.  Yet another argument for why Treasurys are not “safe” investments.[2]

Observing a New York Times article written by Abby Schultz, we finally find a quantitative argument for investing in bonds.  It talks about a new study done by Moody’s, and although it looks like a bit of a stretch, here is a quote that provides some interesting information.  “[The stock market] has been so volatile, in fact, that when swings in market prices are factored in, corporate bonds outperformed stocks on a risk-adjusted basis from Jan. 1, 1990 to the end of May this year.”  The study was based on work done by William F. Sharpe, a renowned professor at Stanford University who also has a ratio named after him, and the rest of the article talks about him.  Sharpe discusses the notion that portfolios should be diversified among asset classes, and that correlations between assets within the portfolio should be considered when analyzing an investment opportunity.  While Lynch would most likely agree with this view, as it is taught in most college investing classes around the world, he would probably argue that his way of diversifying is by investing in different sectors.  However, Sharpe’s rebuttal would probably discuss major market events, such as a crash or something like September 11th, where different asset classes react differently.  Diversifying into different sectors cannot reduce stock market volatility.[3]

 

             After reading the Peter Lynch book, I became amazed by the possibilities that exist, providing one has patience, in the stock market.  I cannot really see how one can argue with a man who, next to Warren Buffett, is possibly the most successful stock picker of all time.  I do not think I will be as extreme as Mr. Lynch in my, what is right now a, potential investments career, however.  I can see myself flooding the bond market when it seems as though some sort of correction (which, of course, lasts longer than one day) is taking place, because it makes sense that when stocks go down, bonds tend to go up.  Bargains in the stock market seem to be one of the greatest opportunities that exist, and after a market correction I envision then taking my money out of bonds and finding some stock bargains.  There is also plenty of evidence provided by Lynch that suggests stocks outperform bonds.  When retirement is looming, I plan to use something to the extent of the 100 percent stocks investment strategy I described earlier.  Of course, the advantage I plan to have will include general investing knowledge, and with plenty of time to investigate stocks during retirement, I can see myself actively managing my retirement portfolio.  True, this is looking 40+ years into the future, but it never hurts to plan ahead.


 


[1] http://www.soundmindinvesting.com/vsection/v_newsletter/0211/feature.htm

[2] http://www.forbes.com/free_forbes/2002/1209/206.html

[3] http://www.globalaging.org/pension/us/private/StokBond.htm

 

Bibliography

Fisher, Kenneth L.  (2002).  Bonds, Not Books.  Published on the Web 12/9/02.  http://www.forbes.com/free_forbes/2002/1209/206.html

Lynch, Peter, with Rothchild, John.  (1994).  Beating the Street.  New York:  Fireside.

National Center for Health Statistics.  (2000).  Fast Stats A to Z:  Life Expectancy.  Published on the Web 11/5/02. 

http://www.cdc.gov/nchs/fastats/lifexpec.htm

            Pryor, Austin, with Biller, Mark.  (2002).  Stocks vs. Bonds:  Picking the Right Mix for Your Situation.  Published on the Web 11/1/02.  http://www.soundmindinvesting.com/vsection/v_newsletter/0211/feature.htm

            Schultz, Abby.  (2002).  Stocks vs. Bonds:  A Risk Scoreboard.  New York Times 6/30/02.  http://www.globalaging.org/pension/us/private/StokBond.htm

 

 

 

 

 

 

 

 

 

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