The Disconnect Between Bonds and Stocks

The current interest rate yield on 10-year U.S. treasury bonds is about 2.6% as compared to about 4% on these same bonds in April of this year.  Those worried about a double-dip back into recession have aggressively purchased the U.S. 10-year resulting in this very low rate.  Comparable rates around the world are similarly low, with German 10-year at about 2.3%.  Japanese 10-year bonds are yielding under 1%, but this is a special situation with years of deflation and the vast majority of such bonds purchased and held by the Japanese themselves.

Now consider stocks.  A buyer of all 30 stocks in the Dow Jones Industrials Average would receive a dividend yield of 2.7%, plus any future dividend increases, plus any future growth in the price of the stocks.  When comparing this to the 10-year U.S. treasury bond yield of 2.6%, a bond buyer is essentially valuing future dividend increases and future stock price growth at zero.  This week we listened to a conference call by a stock mutual fund manager (who manages about $45 billion) where he indicated never in his career had he seen such a compelling case for owning stocks as compared to bonds.

It would seem that only one of these will turn out to be correct- either the case for bonds or for stocks.  Investors should pay close attention to this disconnect as they determine how to allocate their portfolios.

Interest rate history might help today's bond investors

This is a chart of the 10-year US Treasury interest rate going back to 1962.  The rate started 1962 around 4% and over the next approximately 20 years rose to a high of almost 16% in 1981.  The general trend in rates for the 30 years since the 1981 high has been down, with the 10-year US Treasury now yielding approximately 3.2%.

Returns from bonds are helped by declining interest rates and hurt by rising interest rates.  Concerned about stock market volatility, investors moved $379 billion into bond funds in 2009 (while withdrawing $9 billion from stock funds).  Could it be that investors are increasing their bond allocations just before bond returns are again harmed by rising interest rates (like the 20 years starting in 1962)?  No one can say what future interest rates will do, but the above chart does give some nice historical perspective.

Looking back over 2009- Bonds

2009 was for bonds a year where risk paid big rewards, while the safety of places such as U.S. Treasurys (which protected so well in 2008) meant losses.  First let's look at what happened with Treasury yields-- remember that when yields go up, prices go down.  The interest rate paid on the 10-year Treasury note went from 2.25% at 12-31-08 to 3.75% currently while the interest rate on the 30-year Treasury bond went from 2.6% at 12-31-08 to 4.6% presently.  To assess the effect on investors in these instruments, consider the 21% loss for year-to-date return on the iShares 20-year Bond Fund (symbol TLT).

While rising rates hurt investors in Treasurys, the improving economy meant big gains for investors in bonds with some credit risk (meaning some risk of default).  In fact, more risk generally meant more return (just the opposite of 2008).  The iShares Investment Grade Corporate Bond (LQD) has returned about 9% year-to-date.  The Barclays High Yield Bond Fund (JNK) has earned 37% year-to-date.

Is there a lesson in all of this?  To us the dramatic change from 2008 to 2009 for bond investors simply reinforces the importance of not simply following the crowd or reacting to what all of the TV "experts" or cable talk show hosts say.  As always, successful bond investors in 2010 and beyond will be those who perform the hard work of constantly evaluating the risk/return opportunities of different bond sectors, maturities and issuers, and then have the courage to act in a manner that is at times contrary to popular opinion.

Former Treasury official's prescription for deficit reduction

Former deputy US Treasury secretary Roger Altman wrote an opinion article published in the Financial Times this weekend (http://tiny.cc/omEn6) in which he expressed significant concern over the level of budget deficits and their effect on interest rates and the US dollar.  Mr. Altman points out that the continued budget deficits over the next 10 years would result in the Treasury having to borrow $4 trillion annually and asks the question "does anyone think that once recovery takes hold and private demand for capital strengthens, the Treasury will raise $4 trillion per year at below 4 per cent, as it is doing today?"

Altman sees the potential for rising inflation, rising interest rates and significant decline in the value of the dollar unless something is done to get the US budget deficit under control.  His proposal-- legislation creating a bipartisan deficit reduction group of administration and congressional leaders who will study the possible solutions for cutting spending and raising revenues and make recommendations by December 31, 2010 that are then submitted to Congress for an up or down vote.

We can hope our leaders will do something like Mr. Altman has proposed and we can also hedge against the rising inflation, higher interest rates and weaker dollar in the event they don't.