Retired Investors Don’t Buy Bonds Until? by Chuck Carnevale, F.A.S.T. Graphs.
The primary attractions supporting investing in bonds or other fixed income instruments have traditionally been high income and safety. People invest their principal in bonds and receive a stated interest rate (coupon) over the life of the bond and are given the promise of having their principal returned at maturity. Under normal times, bonds would typically pay a higher rate of interest than the dividend rate on stocks. Consequently, bonds have acquired the reputation as low risk and high income instruments.
However, risk is a multifaceted concept. The risk of losing all your money is one of the investor’s greatest fears. Virtually all high-quality bonds eliminate this loss of principal risk. But there are additional risks that bonds do not always protect investors from. Fixed income investments provide little or no inflation protection, especially when interest rates are as low as they are today.
Then, there is liquidity risk. Both stocks and bonds fluctuate in price as a direct consequence of the liquidity they provide investors. The primary determinant of a bond’s price fluctuation is changes in interest rates. When interest rates rise, the prices of existing bonds will fall, and vice versa. In contrast, there are many factors that can cause stock prices to rise or fall. But my primary point is that liquidity risk, when investing in bonds at low rates of interest like we have today, is very high. In the current environment, bonds do not afford much protection against liquidity risk. Stocks may or may not.
The bottom line is that I support investing in bonds when they possess the characteristics of providing higher income than I can get on a dividend stock. In fact, there was a time when I completely avoided investing in stocks altogether, favoring investing only in bonds instead. That time was from 1979 through all of 1985, a period of time when AAA rated corporate bonds were paying double-digit interest rates. When I could get interest rates of 10% to as much as 15% by investing in high-quality bonds, I avoided stocks altogether. It made no sense to me to assume the risk that came from owning stocks when I could get double-digit rates on bonds and be virtually guaranteed to get my principal back.
Unfortunately, today the reverse is true as the rates on high-quality bonds are in many cases lower than the dividend income I can earn on high-quality blue-chip dividend stocks. Therefore, just as I exclusively invested in bonds during 1979-1985, today I am exclusively investing in high-quality blue-chip dividend stocks. However, I consider this a temporary posturing as I would once again enthusiastically utilize bonds when they make economic sense and provide the safety and predictability that they traditionally have.
Rebutting the Rebuttal to My Recent Article
Fellow Seeking Alpha Author Gary Golnik recently authored an article titled “I Can Endure More Bond Duration Than Chuck” in an apparent attempt to retort my recent article titled “How Much Bond Duration Could You Endure?” however, I believe that Gary failed to effectively counter my arguments with his article for the following reasons.
First of all, what Gary failed to point out or recognize, is that 20 years ago when I could have received a 6.82% yield on AAA rated corporate bonds, I would have been delighted to support including them in a retired investor’s well diversified and balanced portfolio. At that time (1996) the dividend yield range on most fairly valued dividend growth stocks was only 1%-3%. Therefore, bonds offered a significant yield advantage.
As a result, the higher yield differential benefit of investing in bonds at that time was worth it. Consequently, I was delighted to support building retirement portfolios balanced between stocks and bonds, especially for retired investors that needed a high level of current income. With interest rates attractive at the time, it was logical to build a balanced portfolio of high-quality bonds laddered across various maturities, coupled with attractively valued dividend growth stocks with lower yields but capital appreciation potential in order to fight inflation.
At that time, a balanced portfolio could easily be designed to be able to adapt to the future when bonds in a rationally designed ladder matured. If capital appreciation was high enough, and the dividend growth stocks were generating enough current income due to growth yield (yield on cost) investors would have the option to reinvest the proceeds in either new bonds or stocks as they chose according to their specific needs and risk tolerances.
Additionally, in 1996 bonds made sense because their yields were high enough to even be considered competitive with the traditional long-term returns of approximately 6%-8% that stocks have historically achieved. Consequently, due to the predictability of their then higher fixed income stream, and the high certainty that your principal would be returned at maturity (at least in nominal terms), it was quite rational to opt for the lower risk qualities available with investing in bonds.
Furthermore, the pricing of previously issued bonds going forward remained strong and healthy because of the continuous downtrend in interest rates that followed. Here I will add that this was not predictable, because forecasting future interest rates never is, but it was an excellent side effect and benefit for owners of bonds previously issued when rates were higher.
Accurately predicting future interest rates remains unpredictable. However, with rates as low as they are today, logic would dictate that the direction of interest rates is more likely to be higher than lower going forward. That would not be a good environment for recent purchasers of bonds. The following historical graph courtesy of FRED (Federal Reserve Bank of St. Louis) of AAA corporate bond yields summarizes the above statements:
The following excerpt from Gary olnik’s article was offered to support his contention that, and I quote: “So while stocks may beat bonds, they don’t beat bonds by enough over the next few years to warrant the risk of a portfolio heavy in stocks.” But as I will soon extensively illustrate, Gary left an important return component out of his comparison. Here is what Gary said and his supporting graphic:
“I’ve finished my thoughts and haven’t referred to a single stock!! Egads, what shall I do? The figure below shows the total growth of dividends over the last twenty years (data from Chuck’s F.A.S.T. Graphs) for stocks compared to the return available from bonds at various rates. I chose a bunch of stocks at random from Mike Nadel’s new DG50 (Southern Co., Kellogg, Realty Income, General Electric, Exxon Mobil, Emerson, 3M, Coca-Cola, Clorox, Hershey, Deere, PepsiCo, Lockheed, Johnson & Johnson) just to illustrate.”
Unfortunately, Gary left out capital appreciation, the most important part of a proper calculation which is the primary reason I don’t like bonds today. To be clear, the above graph compares dividend growth rates only to the interest rate of a bond. Frankly, I don’t see a logical comparison between the two. Gary attributed the results depicted on the dividend growth stocks on