A New Look at The Changed Role of Bonds at a Time of Paltry Yields
Bonds have traditionally been included in portfolios because of their stability, the production of steady interest income and the certainty of principal repayment.
With current interest rates at three-decade lows – and likely to stay low for the near term – bonds no longer deliver viable income for retirees and others who rely on that income. Further, because interest rates and bond prices move inversely, as interest rates eventually begin to rise over time, the value of bonds will assuredly decline. In fact the further out bonds stretch in terms of maturity, the more pronounced will be the decline.
Managing this “duration” risk by shortening maturities means yet lower interest rates, presenting income-seekers with a conundrum. Bond funds provide even greater potential for loss, because while individual bonds have maturity dates when the nominal value will be repaid, bond funds have no maturity date.
Historically interest rates comprise compensation for inflationary expectations and a reward for deferring consumption. By that standard benchmark we estimate that current rates in the USA should be around 2% higher than they now are.
One strategy that deals with this problem is “Bond Laddering” which involves investing in various “rungs” of the ladder. A typical simple ladder might have 5 rungs, whereby an equal amount of money is invested in 1,2,3,4 and 5 year maturities. Every year a bond matures representing 1/5th of the total portfolio, and the proceeds are then reinvested in a 5 year bond to keep the ladder intact. This strategy diversifies over time, smoothing out changes in interest rates and because bonds are bought to be held to maturity, there is never a realized capital gain or loss. In addition once the program is in place, the investor is always buying 5 year bonds and yet the portfolio has a 2.5 year average maturity rate. With an upward sloping yield curve applicable in most market cycles, 5 year returns are typically higher than 2.5 year returns.
Many investors are now taking a fresh look at equities because dividends are a fine substitute for interest at current levels. In fact many Blue Chip companies are paying higher dividend yields than the interest on their corporate bonds.
For example Wal-Mart, Pfizer, GE and Microsoft dividend yields exceed their 2019 maturity bond interest rates by over 50% and with corporate profits strong and growing, many companies have been hiking their dividends. Large scale buybacks of shares by corporations has provided tailwinds to dividend payouts and to stock prices.
To illustrate the powerful effect of growing dividends over time, consider that the annual dividend income earned by Warren Buffett’s Berkshire Hathaway now exceeds the entire cost of the investment made beginning in1988.
NAME OF COMPANY |
2019 BOND YIELD |
DIVIDEND YIELD |
| Wal-Mart | 1.85% | 2.6% |
| Pfizer | 1.97%; | 3.3% |
| GE | 2.23% | 3.5% |
| Microsoft | 1.50% | 2.9%; |
More important than dividends of course are the underlying earnings of corporate America because as Buffett sagely advises, shareholders are in reality partners in the enterprises and should think like owners not speculators. The earnings yield on a well selected equity portfolio is around 6 -7% currently, compared with the interest rate on the 10 year Treasury which is currently 2.75%. This ratio is typically around 1x and is now more than 2x. Unless corporate earnings plunge or interest rates soar (neither of which we believe is about to occur) this bull market likely has plenty of room to keep charging forward – of course with bumps along the way. Beyond the USA, we see global yields at low levels in established foreign markets. Even the 10 year sovereign bonds of less stable economies like Italy, Spain and Ireland are at 3.5%, 3.6% and 3.1% respectively.
Dividend yield-based investment strategies, which focus on both income and capital appreciation, have proven to produce stable, growing income streams. In addition to constituting a meaningful portion of total return, numerous academic studies have shown that dividend payers tend to outperform non-dividend payers across market cycles and offer higher risk-adjusted returns. Dividends also play another important role during periods of volatility. While price returns can be either positive or negative, dividend incomes are by definition positive. Therefore, dividends provide investors with the opportunity to capture the upside potential while providing some level of protection in negative markets.
While most investors regard stocks as risky and bonds as safe, it might be just the opposite in the current climate. For some perspective, keep in mind that there is not a single 7 year period in the last 75 years where long term investors in the major US or UK equity indexes lost money, yet in many of those 7 year periods, investors lost the majority of the buying power of their investment through the ravages of inflation. Of course over short periods of time stocks appear to be volatile – but one of the keys to successful investing is to distinguish risk (the possibility of permanent loss) from volatility (the market’s successive overpricing and underpricing stocks, commonly known as bull and bear markets). Think of volatility as turbulent plane journey and risk as a plane crash. They both feel the same at the beginning.
Morningstar estimates that equity markets tend to deliver 9 – 10% annually inclusive of dividends over the long term, yet most investors actually earn about a quarter of that because they are simply unable to endure the pain of market cycles. Although history is solidly on the side of the bulls, the crowds typically buy near the top and sell out in the panics. For example in 2013 the Dow Jones Index had 45 record closes and gained 26% for the year despite fears of a US Government shut down, the feared ending of Quantitative Easing and numerous global threats. “Main Street” has yet to rediscover “Wall Street” because most neophytes are still licking their 2008 wounds. Many are unaware that the S+P 500 has appreciated by almost 300% inclusive of dividends since it reached a low of 667 in March 2008.
Because bonds and equities work in opposite time frames, combining them may provide the optimal answer to those seeking income with long term growth and safety. Laddered bonds produce predictable income and cash flow in the near term, while quality equities provide increasing dividends and appreciation over the longer term. A properly designed portfolio with a 25 – 30% bond allocation and the balance in a select grouping of equities with an orientation towards the larger global brands and dividend paying stocks in a low cost manner should comfortably provide a draw rate of 5% annually and remain fully intact, with inflation protection.
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