The Bond Buyer's Dilemma - B Malkiel

[Midpack]

I am not happy with my bond holdings, but I'm not sure these approaches make me more comfortable (just looks like trading more risk for potentially higher returns, lots of ways to do that) I wish they did. But I'm no expert, so maybe useful to others...
Burton G. Malkiel: The Bond Buyer's Dilemma - WSJ.com

Are we in an era now when many bondholders are likely to experience very unsatisfactory investment results? I think the answer is "yes" for many types of bonds—and that this will remain true for some time to come.

 

[MichaelB]

I know what you mean. He seems to be concerned with future value. Someone in the accumulation phase should already have a large allocation to equities, and someone in the withdrawal phase needs to be concerned with portfolio survivability, not total return. I wonder what his advice would be if asked what allocation would make the portfolio safer for a recent retiree looking at 30+ years but needing regular withdrawals?

 

[W2R]

I am not happy with my bond holdings, but I'm not sure these approaches make me more comfortable (just looks like trading more risk for potentially higher returns, lots of ways to do that) I wish they did. But I'm no expert, so maybe useful to others...
Burton G. Malkiel: The Bond Buyer's Dilemma - WSJ.com

I completely agree that he is suggesting trading more risk for potentially higher returns.

He says,

Even if inflation over the next decade averages 2%, which is the Federal Reserve's informal target, investors will find that they will have earned a zero real rate of return.

but I always thought inflation was addressed by the equity portion of my portfolio, not the bond portion; I am happy with my bonds if they keep up with inflation.

 

[Lsbcal]

From Malkeil article:

Another class of bonds that is attractive today is foreign bonds in countries that have much better fiscal balances than we have in the U.S. An example would be Australia, which has a low debt-to-GDP ratio (about 25%), a relatively young population and abundant natural resources, making its future economic prospects bright. Its currency has been appreciating against the U.S. dollar. High-quality Australian private bonds are available at yields of 8%.

This seems to be what Bill Gross (Pimco Total Return) is saying, "the cleanest dirty shirts".

My own research indicates that a switch strategy between Cash and Intermediate Bonds could have achieved decent real returns in the 1950's and 1960's when rates generally rose (5yr Treasury rose from the 2% range to the 7% range). So that's what I'm doing now in part of the bond portfolio.

 

[RioIndy]

This article is surprising to me, as I found that so far in 2011 (which my first year with significant investments), that while I chose to skip on allocating anything to a bond index fund since I still have a long time horizon, but observed that a bond index fund would have handily outperformed my equities by a large margin.

 

[Hamlet]

I much prefer this strategy compared to buying bonds at current rates

Another strategy would be to substitute a portfolio of blue-chip stocks with generous dividends for an equivalent high-quality U.S. bond portfolio. Many excellent U.S. common stocks have dividend yields that compare very favorably with the bonds issued by the same companies.

 

[Midpack]

I wonder what his advice would be if asked what allocation would make the portfolio safer for a recent retiree looking at 30+ years but needing regular withdrawals?

Me too. Most of my investing research fits that description since it describes me. There remains no place to hide these days IMO, but one of these days I'll find something or conditions will restore asset class characterics to something closer to past decades.

 

[haha]

This article is surprising to me, as I found that so far in 2011 (which my first year with significant investments), that while I chose to skip on allocating anything to a bond index fund since I still have a long time horizon, but observed that a bond index fund would have handily outperformed my equities by a large margin.

This may be confusing past preformance with returns available at the time of purchase. For every basis point that a bond investment earned yesterday, there is one less basis point for it to earn tomorrow. You buy a bond and hold it to maturity, barring default you get its YTM at time of purchase, no matter how much it might bounce around in the interim. This may be otherwise if you are a successful bond trader.

Since the fixed income market is now under 100% full on government manipulation, the only question left is might they fail? Certainly the bond vigilantes of the 70s and 80s have been revealed as useless wimps of the 00s and 10s.

Ha

 

[jebmke]

He sort of blew himself up when he said this.

Another strategy would be to substitute a portfolio of blue-chip stocks with generous dividends for an equivalent high-quality U.S. bond portfolio.

 

[Hamlet]

Why? I feel much safer owning solid large dividend-paying companies right now than bonds paying less than the current inflation rate.

He sort of blew himself up when he said this.

 

[eytonxav]

At this point in time, and given the lack of many good alternatives, I don't see anything wrong with the dividend stock approach vs holding treasuries that are paying next to nothing and that will likely take a big hit when rates creep up.

 

[Lsbcal]

I've had my AA pretty rich in equities. But from what I've seen and recall in studies, dividends are not the best determinant of value investing. It could be that higher dividend stocks will outperform in the near term though.

Equities really aren't a substitute for bonds IMO. Though I agree that bond real returns going forward are not likely to be juicy.

 

[Midpack]

At this point in time, and given the lack of many good alternatives, I don't see anything wrong with the dividend stock approach vs holding treasuries that are paying next to nothing and that will likely take a big hit when rates creep up.

Fair question, but you can pretty well predict the downside for bonds, not so for dividend paying equities which may have a big upside or a downside far greater than bonds. So you are taking on more risk, not a substitute for bonds. No right answer that I know of...

 

[eytonxav]

Fair question, but you can pretty well predict the downside for bonds, not so for dividend paying equities which may have a big upside or a downside far greater than bonds. So you are taking on more risk, not a substitute for bonds. No right answer that I know of...

Well if your treasuries (especially longer term ones) see a big uptick in rates the downside will also be great. In this environment, I feel there is a valid case for spreading your bets across different types of dividend paying investments (stocks, bonds, preferreds, CEF) vs staying only in traditional safe havens treasuries that pay close to nothing. Of course if you don't want to monitor closely, such approach may not be to your liking, especially if you are a buy and hold indexer.

 

[Midpack]

Well if your treasuries (especially longer term ones) see a big uptick in rates the downside will also be great.

Not as great as equities if history is any indication. If there's a financial meltdown (not a prediction), bonds and cash returning next to nothing or somewhat negative real returns may be preferrable to equities - which is what the non-equity portions of our AA's are for.

In this environment, I feel there is a valid case for spreading your bets across different types of dividend paying investments (stocks, bonds, preferreds, CEF) vs staying only in traditional safe havens treasuries that pay close to nothing.

No argument. My point is simply that he's trading more risk for potentially higher returns, that's not news or any insight at all IMO. If OTOH you know of an asset with better returns than bonds currently, with the same or less risk, you have the basis for a great article...

 

[jebmke]

Why? I feel much safer owning solid large dividend-paying companies right now than bonds paying less than the current inflation rate.

History has shown that stocks are riskier than bonds.

 

[Hamlet]

I think we have very different ideas about what the risks of buying bonds at current prices are.

I feel that long-term bonds are currently one of the riskiest assets around. I think that there is a high likelyhood that someone buying a 10-year Treasury today and holding it to maturity will lose purchasing power over that time period.

There are a lot of stocks out there with very strong balance sheets, low PE's, and yields that are significantly higher than that Treasury.

I think that someone purchasing a basket of ten or so stocks like Coke, Proctor and Gamble, and Microsoft is actually taking less real long-term risk than someone buying 10-year Treasuries today.

If OTOh you know of an asset with better returns than bonds currently, with the same or less risk, you have the basis for a great article...

 

[Midpack]

I think that someone purchasing a basket of ten or so stocks like Coke, Proctor and Gamble, and Microsoft is actually taking less real long-term risk than someone buying 10-year Treasuries today.

We all realize your [-]gamble[/-] suggestion might pay off, but show us your data to support less risk with dividend stocks vs treasuries...I can't find anything to support your hypothesis in the long run. In the end, all you're suggesting is increasing the equity position in your asset allocation, that's not a substitute for the purpose of bonds. I assume you're 100% equities?

 

[jebmke]

I keep duration very low (for nominal bonds) - interest rate risk is minor and inflation risk is low-moderate. TIPS in longer duration so negligible inflation risk there but the duration is matching a longer liability.

I keep equity at a level where I can afford to lose 75% of the value for 15-20 years without crimping my lifestyle. Nobody knows for sure but there is a reasonable chance we are in Japan mode for another decade or two. At least, that is the way I am planning my worst case. Besides, if there is a big uptick in rates, equities will probably get creamed too.

 

[Spanky]

I keep equity at a level where I can afford to lose 75% of the value for 15-20 years without crimping my lifestyle.

I assume that your equity level is either low or you have other resources to fund your expenses.

 

[jebmke]

I assume that your equity level is either low or you have other resources to fund your expenses.

Equity level is 40%. Yes, the other resources are in bonds of low duration.

But in any case, I think it is risky to build a retirement plan that depends on equity returns without a backup plan that is sustainable during a protracted period of poor results. The back up plan may range from cutting back lifestyle, going back to work or telling the heirs that there is nothing coming.

I don't try to forecast the outcomes -- I have no idea what will happen. But a long period of continued under performance of equity or even another severe drop with no recovery for years is a possible outcome.

When someone starts thinking of stocks and bonds as being in the same risk class, I cringe. I am reminded of a saying that a colleague of mine used to have "one thing I like about investing in stocks is that the most you can lose is all your money."

 

[Hamlet]

I am 100% equities.

What do you expect inflation to be over the next ten years? It is currently running at 3.5%. The 10-year Treasury is currently yielding 2%. So if nothing changes, each year you hold that Treasury you will lose about 1.5% of your purchasing power.

If you expect inflation to be zero over the next ten years, you will make a real return of 2% a year. The only way you can expect your rate of return to be better than that is if you expect there to be long term deflation. Long term deflation is a tough thing to have when the government can print money to correct it.

If inflation picks up, the people holding long-term bonds are going to have losses that are similiar to the losses people holding stocks had in the recent decline, ie 30-40% losses. Taking that risk for an upside of 2%/year seems foolish.

At least when you gamble by buying stocks today, there is a reasonable chance that you won't lose purchasing power by buying them. I don't see much chance of that with bonds at current prices.

We all realize your [-]gamble[/-] suggestion might pay off, but show us your data to support less risk with dividend stocks vs treasuries...I can't find anything to support your hypothesis in the long run. In the end, all you're suggesting is increasing the equity position in your asset allocation, that's not a substitute for the purpose of bonds. I assume you're 100% equities?

 

[nun]

Well if your treasuries (especially longer term ones) see a big uptick in rates the downside will also be great. In this environment, I feel there is a valid case for spreading your bets across different types of dividend paying investments (stocks, bonds, preferreds, CEF) vs staying only in traditional safe havens treasuries that pay close to nothing. Of course if you don't want to monitor closely, such approach may not be to your liking, especially if you are a buy and hold indexer.

Psst, Wellesley (YTD 7.53% return) or Wellington, and a pile of cash

 

[eytonxav]

Psst, Wellesley (YTD 7.53% return) or Wellington, and a pile of cash

Psst, thats my largest individual fund holding (admiral shares of course) aside from my cash position

 

[haha]

But in any case, I think it is risky to build a retirement plan that depends on equity returns without a backup plan that is sustainable during a protracted period of poor results.

I am not an advocate for 100% stocks, and even less for cap weighted indexes. I do tend to be pretty heavy in equities most times.

But clearly bonds of any even medium duration are a certain loss if bought and held.

Look back at 2008-2009 and see how many high class companies not only continued their dividends unreduced, but how many kept raising the dividend every year or so. Just don't try this if you are folowing a liquidation for expenses strategies, which I really do not recommend anyway. If you can live on your dividends, it may be that all you need is solid businesses that pay rising dividends, and some emergency money kept in very low duration instruments.

Read JM Keynes remarks on investing during the Great Depression in England and America, in Keynes, Economic Articles and Correspondence, Vol. XII.

Ha