Bonds’ future fortunes are flagging

Past performance is no guarantee of future returns, as the familiar disclaimer on investment products warns. Buying what’s been going up, which is called momentum investing, feels more comfortable than buying what few others want.

Humans are social creatures, and most would rather find reasons to agree than hold a minority view. Successful investing requires looking forward. History is relevant, though positive real returns can come only from investing on terms that provide a reasonable probability of beating inflation. The math of yields and of the amount of debt, as well as the politics, are all increasingly biased against today’s bond investor. Much of the return of recent years has been fueled by capital gains through falling yields on long-term bonds. Today’s yields are close to, if not at, the point where further capital gain is not possible.

Returns will simply be the interest rate on the bonds, and nothing more. The long bull market has pretty much run its course. Yields may move higher, inflicting actual losses on investors, or they may remain tethered by the Federal Reserve to 0% short-term rates. It’s time for bondholders to begin looking elsewhere, for three reasons.

First, transaction costs for the retail buyer have always been too high. Investors have paid far more in markup to brokers than they should have. Incredibly, the bond market of the 1920s and 1930s offered clients a better deal than today. A bull market and the absence of accurate price information have prevented this from being as apparent as it should be. Clients don’t know and brokers won’t tell them, but the data are clear in that retail buyers pay far too much for relatively safe securities. Perhaps the buy-and-hold investor need not care, yet when yields are pegged between 0% and approximately 3%, the 1% or more markup that’s common represents an unacceptably big chunk of the possible return.

Second, nominal yields that are close to and below inflation ensure that the investor will get back less purchasing power than he gave up when he bought the bonds. Figure in taxes and it’s worse. Moreover, real rates on government and investment-grade credit are unlikely to provide the 2% to 3% cushion above inflation that ought to be the minimum requirement of lenders. Government policy of maintaining a cost of borrowing that’s negative after inflation will remain successful, as it has been at other times of high public indebtedness.

In the public interest

Lenders are increasingly a minority, and their interests clearly don’t figure as highly as those of the far more numerous debtors. Debt owed by federal, state and local governments; households; and students, as well as other substantial obligations such as unfunded public sector pensions and entitlements, create an enormous public interest in the lowest possible cost of borrowing.

As a society, we want low rates, and the Federal Reserve is pursuing policies that are clearly in the public interest. Short-term interest rates that are most easily controlled by the Fed are likely to remain low for years. When the Fed begins raising rates, its ability to push them above inflation will be constrained by its dual mandate, which in-cludes maximum sustainable employment.

It will likely raise rates cautiously, lagging inflation, although it’s entirely possible that it may have to raise rates quickly. Neither outcome will be pleasant for fixed-income investors. Furthermore, the Fed will have to give attention to the $36 trillion of debt throughout the economy, whose servicing costs will rise, slowing growth and raising unemployment and political pressure.

Long-term rates may remain tethered to short-term rates and stay low, or they may drift higher as private investors impose a higher inflation premium. A steepening yield curve with negative real rates for short maturities is hardly the place for investors to find attractive returns.

Third, even earning a return on bonds that beats inflation after taxes doesn’t ensure a secure future for those planning their retirement. Inflation measures a standard of living that stands still, based on a basket of goods and services whose utility, or value, is fixed. Merely keeping up with inflation results in a steadily falling standard of living.

The downward price adjustments for quality improvements, as everything from electronic goods to automobiles gets a little better, is not intuitive to most people. The government’s treatment of housing costs is frankly bizarre and exists to suit the statisticians and their theories while having little to do with the real world, where consumers wrestle with housing costs not directly measured by the consumer price index at all.

Many analysts forecast that if America doesn’t deal with its deficit, rates eventually will move sharply higher, reflecting increasing risk of default through inflation. They worry that China may start dumping some of the $1.2 trillion in U.S. government debt that it holds, stopping the economy in its tracks. It’s worthwhile to consider this possibility. The range of possible outcomes is wide, and this is a real one. However, you don’t need to believe that such an outcome is the most likely one in deciding to avoid bonds. Rates that remain where they are will turn out to be confiscatory. Rising rates and higher inflation will make it worse.

In too deep

I think that America’s foreign creditors are in too deep to be much of a threat. They hold so much of our debt because there’s no other market sufficiently big and liquid to absorb the reserves they wish to hold. If China held, say, $50 billion to $100 billion in bonds, maybe over time, they could exit without driving rates up in the process. However, at their current size, they simply can’t sell. They are in for the duration. When you owe somebody a trillion dollars, it’s as much their problem as yours. China will get back what we want them to get back.

Frankly, I like our position better than theirs. It’s a negotiation that will take place through America’s fiscal policies and the foreign-exchange value of the U.S. dollar over many years. That view may be wrong, but being wrong needn’t cost the investor who recognizes that yields are, in any case, too low to compensate for the risks.

As our domestic expenditures shift toward paying for unfunded entitlements such as Medicare and interest to foreign holders of our debt, consider how the political mood may start to move against the foreign lenders, who provided finance and muffled the warning that higher rates could have provided.

Foreign governments have seen it in their interests to facilitate a transfer of wealth from one generation to another and have confidently assumed that a younger generation of taxpayers would willingly accept the moral obligation to repay what their forebears failed to save. Today’s buyers of 30-year debt assume no culpability in helping one group take from another.

Will subsequent taxpayers and voters accept their unwanted obligations willingly? Or will they reason that the buyer of long-term bonds deserves to bear some of the cost of their actions? Negative real returns and a depreciating currency will be the most obvious way to modify repayment terms, yet if our children ultimately decided on more-severe forms of debt modification, who could blame them? Bonds have been great for a very long time, but today, bonds are not forever.

Make your own bond

So where should investors go in their search for more-reliable ways to preserve the purchasing power of their savings? The answer is equities. U.S. common stocks come in many flavors, provide growth opportunities and also offer an extremely fair deal to investors in terms of transaction costs. Many small and large investors are still reeling from the credit crisis and a poor decade of performance from stocks. This feeling is understandable, yet looking back is rarely the best way to assess investment opportunities.

The concern that stocks can fall, perhaps a long way — eviscerating savings in the process — can be handled by holding some cash, as well. Moving fully from bonds to equities is too radical a move. Nevertheless, cash, even yielding close to 0%, can be used as a risk enabler.

In fact, the Fed’s successful manipulation of interest rates below where they would otherwise be has rendered an entire asset class devoid of an acceptable return. It’s their response to a crisis that was induced by excessive debt, but there’s no reason for investors to help the process along. The Fed is a noneconomic buyer. It doesn’t seek to earn a positive real return on its investments — in fact, if sufficiently robust economic growth drives rates higher and causes the Fed to lose money on its leveraged holdings, it might well regard its policies as having been successful. Clearly, the private investor in bonds would not.

The Federal Reserve has become increasingly open about its objectives and expectations in recent years. It publishes its own forecasts for interest rates, gross domestic product, employment, and inflation. Ben S. Bernanke holds regular press conferences following each meeting of the Federal Open Market Committee, which meets every six weeks or so to set interest rate policy. It’s worth noting that the Fed’s own equilibrium forecast for short-term interest rates is 4%. It’s long been buying securities at all maturities at yields well below this. While it’s not clear when the Fed will raise rates to 4%, the startling implication of this is that it doesn’t think bonds are a particularly good investment for private savers.

To anybody who will listen, the Fed is plainly saying, “We don’t recommend that you do what we’re doing.” If bond investors turn around and discover with dismay that their holdings have lost substantial value, they really can’t blame the Fed for not communicating its objectives clearly. It doesn’t think you should own bonds.

The yields on stocks and bonds are surprisingly close nowadays. The big difference is that stock dividends grow, whereas bond payouts are fixed. The dividend growth on stocks represents a significant form of inflation protection. If consumer prices start rising, many big companies will respond by raising the prices of the goods and services they sell. Some will possess more pricing power than others, and it will be an uneven process, to be sure, but far better than owning securities whose payouts are fixed no matter what the future holds.

The dividend growth potential in stocks means that a small portion of what you hold in bonds can be put in stocks and achieve a similar return. In effect, you can create your own bond by selling the bonds you own and dividing the proceeds between stocks and cash … The amount of stocks you’d need to hold depends on where bond yields are, compared with the dividend yield on the S&P 500. It doesn’t require much of an equity holding to beat bonds.

The two key assumptions are:

1. Dividends will grow at 4% annually, which compares with a 50-year average of 5%.

2. Valuations, in terms of price-earnings ratio or dividend yield, are broadly unchanged in 10 years.

This second assumption may strike some as unrealistic. There’s never agreement on whether stocks are cheap or expensive. So consider a couple of additional points: Dividends have grown at 5% annually, even while companies have paid out successively less of their profits each year. Over 50 years, the payout ratio (the percentage of profits paid out in dividends) has dropped from two-thirds to one-third. Companies are buying back more of their stock as a way to return value to shareholders.

The other consideration is risk. Suppose stocks fall in value by 50%. Holding cash provides valuable stability and greatly reduces the loss of value experienced by the investor.

A portfolio of low-beta stocks provides equity exposure with less volatility than being invested in the overall market. Value stocks are equity risk. The point is that there are enough sectors and ways to arrange stocks that you can invest in several strategies that range from income-generating potential to growth opportunities and turnaround stories. The thoughtful investor can shun bonds, and yet, through a combination of these strategies and cash, weighted according to his return objectives and risk tolerance, construct a portfolio with much better prospects of retaining its purchasing power than one including the returnless risk of bonds.

Fundamental optimism

Moreover, this approach is fundamentally optimistic, but not recklessly so. America is an amazing country. It is truly the shining city on the hill. I am an immigrant myself, having grown up in Britain. I am very proud of my heritage and of the values Britain shares with the United States. However, I also know the intense desire of an immigrant to move here, and after more than 30 years, my conviction of the rightness of that decision remains as strong as ever.

Since its founding, the New World has confounded doomsayers, as Americans have confronted challenges, surmounted them and provided inspiration to so many. Its economy is as flexible and dynamic as any in the world. No doubt, we face substantial problems with the obligations we have amassed. Working through them won’t be painless, and some may conclude that our best days are behind us.

However, 237 years of history make that look like a bad bet. Perhaps the most risky decision is the apparent rejection of risk so many bond investors are making today. Through their investment choices, they are conceding to a steady loss of purchasing power as the best that they can expect for the future. By shunning exposure to America’s entrepreneurial spirit and perpetual economic reinvention, they are implicitly betting that our star is falling. In the long run, that will be the most risky bet of all.

Excerpted from “Bonds Are Not Forever: The Crisis Facing Fixed Income Investors” by Simon A. Lack. Wiley, 2013