A New Approach to Bonds

Countless investors and financial advisors wrestle today with the conundrum of how to approach bonds. We are reminded constantly of the likelihood of rising interest rates; most recently Fed chair Janet Yellen reiterated the case for a hike in short term rates later this year. She argued that uncertainty over Greece was likely to be merely a near term concern, and equity market turmoil in China did not deserve even a mention. It has been well forecast, if not overly forecast, for some years now. The Fed has consistently been too early in their expectations of timing, but it’s looking increasingly as if 2015 really is it.

As if walking a tightrope, today’s investors are forced to balance the impact of changed Fed monetary policy on bonds with their faith that holding an allocation to bonds must remain part of their portfolio construction. It’s a radical thought to reject bonds entirely — and yet that’s what we’ve done at SL Advisors since its formation in 2009. Reasoning that the government really doesn’t want you to own bonds (else why set rates at such unattractive levels) I wrote in Bonds Are Not Forever that  when public policy is to transfer real wealth from savers to borrowers, thoughtful investors take their money elsewhere. Not only are bond investors routinely subjected to insults to their intelligence by bond yields that fail to cover inflation plus taxes, but rowdy borrowers are increasingly announcing that they can’t repay what was owed, as I noted in our recent newsletter. Greece is seeking debt forgiveness (since winning independence from Turkey in 1822 the country has been in default 50% of the time); Puerto Rico’s governor announced they cannot repay their debt. Reaching for yield can mean sharing in the problems of the profligate. Consequently, we haven’t invested our clients’ capital in bonds for many years, and don’t see that changing until yields are more attractive (perhaps double current levels on ten year treasuries).

In this weekend’s Barron’s the cover story makes the case for abandoning bonds altogether.The article makes the case (as we have for years) against low fixed interest rates. It will probably attract the attention of many individual investors although I believe a serious omission has been to overlook Master Limited Partnerships, one of the most attractive income generating investments around with a current yield of around 6.45% on the Alerian Index and a long history of steady distribution growth.

A few years ago we sought to articulate the case for stocks over bonds by illustrating the relatively small amount of capital one needed to allocate to stocks in order to achieve the same cash return as with bonds. The crucial point is that coupon payments from bonds are fixStocks vs Bonds July 11 2015 (Stocks)ed while stock dividends grow. The S&P500 currently yields around 2%. Historically, dividends have grown at around 5% annually. So if you invested $100 in stocks today you’d receive a $2 dividend after the first year but if past dividend growth of 5% annually continued, in ten years your $2 dividend would have grown to $3.26. Put another way, if dividend yields are still 2% in ten years time, your $100 will have grown to $162.89 (that’s the price at which a $3.26 dividend yields 2%).  Since returns on stocks come from dividends plus their growth, a 2% dividend plus 5% growth equals a 7% return. Naturally, the two imponderables are (1) will dividends grow at 5%, and (2) will stocks yield 2% in 10 years (or put another way, where will stocks be?). These are the not unreasonable questions of the bond investor as he contemplates a larger holding of risky stocks in place of bonds with their confiscatory interest rates.

The thing is, while nobody knows the answer to these two questions, it doesn’t take much of your capital in stocks to replicate the cash return you might achieve with bonds in the scenario just outlined. The Treasury Bond Interest chart (Source: SL Advisors) shows the annual interest on a 2.3% yielding bond (the current level on ten year treasury notes)  if you invested $100 (assuming a 40% tax rate, approximately the top margin Federal income tax rate, so $2.30 annually falls to $1.38). The Stocks Total Return chart (Source: SL Advisors) shows the return from investing just $25 in stocks, so the $0.50 dividend (2% on $25) is, after 24% taStocks vs Bonds July 11 2015 (Bonds)xes, around $0.38. This assumes the Federal dividend tax rate and the ObamaCare surcharge but excludes state taxes.

The intent is to show visually what the Math does, which is that given the assumptions described you only need use 25% of your bond money invested in stocks to achieve the same cash return that you might expect from bonds. While switching out of bonds into stocks might sound imprudent to many, the real choice is between $100 in bonds or $25 in stocks with the other $75 in Cash. The 25/75 barbell portfolio of stocks and cash can quite plausibly replace the bond portfolio. If stocks fall 50%, your barbell would lose a quarter of that, or 12.5%. Whereas, a move in ten year yields from, 2.3% to 4% would cause the same loss of value. Consider for a moment which is more likely.

Of course, an investor may prefer the certainty of a loss of real value after inflation and taxes that bonds offer, compared with the uncertainty of stocks. In effect, that is what every bond investor is choosing by virtue of owning bonds. But in the 25/75 barbell portfolio we’ve assumed that there’s no return to the cash portion, and while that is more or less true today it will change over ten years; in fact, cash will probably begin earning a return (albeit still small) later this  year if Janet Yellen does as expected. The Math of stocks over bonds is compelling. It’s this analysis that has informed our rejection of bonds for years. This is the unspoken logic behind Barrons and their article, A New Approach to Bonds. It’s not quite as new as they think.

Print Friendly, PDF & Email

Important Disclosures

The information provided is for informational purposes only and investors should determine for themselves whether a particular service, security or product is suitable for their investment needs. The information contained herein is not complete, may not be current, is subject to change, and is subject to, and qualified in its entirety by, the more complete disclosures, risk factors and other terms that are contained in the disclosure, prospectus, and offering. Certain information herein has been obtained from third party sources and, although believed to be reliable, has not been independently verified and its accuracy or completeness cannot be guaranteed. No representation is made with respect to the accuracy,  completeness or timeliness of this information. Nothing provided on this site constitutes tax advice. Individuals should seek the advice of their own tax advisor for specific information regarding tax consequences of investments.  Investments in securities entail risk and are not suitable for all investors. This site is not a recommendation nor an offer to sell (or solicitation of an offer to buy) securities in the United States or in any other jurisdiction.

References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and do not reflect the deduction of the advisor’s fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase. Indexes and benchmarks may not directly correlate or only partially relate to portfolios managed by SL Advisors as they have different underlying investments and may use different strategies or have different objectives than portfolios managed by SL Advisors (e.g. The Alerian index is a group MLP securities in the oil and gas industries. Portfolios may not include the same investments that are included in the Alerian Index. The S & P Index does not directly relate to investment strategies managed by SL Advisers.)

This site may contain forward-looking statements relating to the objectives, opportunities, and the future performance of the U.S. market generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involves a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of SL Advisors LLC or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made. r

Certain hyperlinks or referenced websites on the Site, if any, are for your convenience and forward you to third parties’ websites, which generally are recognized by their top level domain name. Any descriptions of, references to, or links to other products, publications or services does not constitute an endorsement, authorization, sponsorship by or affiliation with SL Advisors LLC with respect to any linked site or its sponsor, unless expressly stated by SL Advisors LLC. Any such information, products or sites have not necessarily been reviewed by SL Advisors LLC and are provided or maintained by third parties over whom SL Advisors LLC exercise no control. SL Advisors LLC expressly disclaim any responsibility for the content, the accuracy of the information, and/or quality of products or services provided by or advertised on these third-party sites.

All investment strategies have the potential for profit or loss. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client’s investment portfolio.

Past performance of the American Energy Independence Index is not indicative of future returns.

Print Friendly, PDF & Email
0 replies

Leave a Reply

Want to join the discussion?
Feel free to contribute!

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.