Do you know why you own bonds in your portfolio? There are many reasons to own bonds but one of the biggest reasons historically is no longer a good one for many investors. Bonds are often held in portfolios to provide a safe and steady source of income, in particular for retired investors. But the long bull market in bonds is at best in its final innings and thus they no longer meet the goal of providing a safe and steady source of income. Lets take a look at some data and see what it tells us about bonds today.
The first chart I picked up the other day from Abnormal Returns and shows one measure of how much bonds may be over valued today.
The average dividend stock now yields a good deal more than AA rated US corporate bonds. And you get dividend growth to boot. But hey stocks are risky so most conservative investors wouldn’t put much salt in this chart I think. What if we could project what the 10 year forward returns for bonds will be? Well, it turns out you can. The current yield is the best indicator for 10 yr forward returns. Take a look at the chart below from O’Shaughnessy Asset Management . Read the whole analysis when you get the time.
Read the callout carefully. If bonds follow historical precedent they will return 0.59% per year through December 2021! Since these are nominal returns we then need to back out inflation and since bonds are taxed as ordinary income we need to take out taxes as well. Returns are so small you can pretty much ignore taxes but inflation will take bond returns negative to about -2.44% per year through 2021. If past is precedent investors will loose money in intermediate gov’t bonds over the next 10 years. So much for a safe and steady source of income. You might say fine, I’ll just go out the yield curve or take some credit risk by investing in long term treasuries or corporate bonds. The OSAM findings hold for those bonds as well. Yes, you will earn more than intermediate bonds but current yields are still the best predictor of forward returns. With both long term treasuries and corporates yielding less than 3% and inflation probably staying in the historical 3% range you are looking at zero real returns.
If you hold bonds in a mutual fund, ETF, CEF, or even individual bond issues one of the ways you have seen the effect I’m describing is lowered distributions from these funds. Look at the payouts of most bonds funds and you see income from the funds going down over the last several years. This is because as old bonds mature the new money is re-invested at lower yields and thus over time the distributions from these funds come down. Over the past several years this income reduction has been more than offset by capital appreciation from falling yields but as the OSAM study shows this is probably coming to an end. Again, so much for safe and steady income.
Maybe this time is different. The only situation that would make the above not happen is a new deflationary type scenario ala Japan. In that case yields will continue to fall and capital appreciation in bonds will make up for falling yields and since most other asset classes will fall as well, bonds will be the best house in a bad neighborhood. What would a Japan yield scenario be like? Below is a chart of Japanese 10yr government bonds yields back to Jan 2000.
Lets say we’re headed for a Japan scenario and US ten year yields will head to 0.5%, as low as they’ve been in Japan, in the next 5 years. With the US 10 year current at about 1.58% what would be the total return to these bonds if yields fall to 0.5%. It’s probably not as high as you think. The total return of from such a scenario would be about 12%. That’s it. That’s the thing with low current yields. The bang for the buck from lower yields is not as great. 12% over 5 years in a deflationary scenario is not bad, maybe it even happens over fewer years, but its not the bond bull market of the past especially after taxes and inflation. I don’t think the odds of this scenario are very high and even if I did the upside from this scenario is not great.
I do think bonds still have a place in a portfolio but for different reasons. To me they are great diversifies and a great place to stash cash while you wait for better opportunities in riskier assets like stocks. Bonds also have an important place in portfolios such as the IVY and Permanent portfolios as diversifiers where automatic rebalancing will have you adding money as bonds become a better value. Even better timing the IVY or the Permanent portfolios will get you out of bonds when they start a new down trend. For example, in the IVY timing model, a drop of about 3% in the IEF bonds ETF would have you out of bonds all together.
In summary, bonds are priced at the point where they no longer offer safe and steady income especially after considering inflation and taxes. While bonds are still important portfolio diversifiers there are better alternatives for many investors. The best alternative to bonds is a conservative dividend portfolio. As the first chart above showed many dividend paying stocks pay more than bonds and offer increasing income as well. The two most conservative and stable dividend sectors for investors to consider are utilities and consumer staples. While not my favorites for total return as bond replacements or enhancers they make a lot of sense in today’s environment. I’ll have more to say on utilities and consumer staples as alternatives to bonds in a future post.