The other day Matthew noted a Deutsche Bank study that reported that Dutch Sovereign bonds are paying near their lowest yields since 1517, which is as far back as anyone has records. No matter where you go, interest rates seem ridiculously low. Here in the United States the bellwether 10-year Treasury note has a yield of about 2.5%, which is not a record but it is close. Tax-free municipal bonds pay about as much. I recently saw these three offerings in the Pennsylvania municipal bond market that mature in 16, 18 and 20 years:
Investment grade corporate bonds yield a little more than Treasuries and municipals, but not much. High-yield bonds, otherwise know as junk bonds, a little more still, but are unacceptably risky. They are called junk bonds for a reason.
So we come to the big question: Why would anyone buy bonds with yields this low? In the following words let me set forth five specific reasons, gleaned from recent conversations in our daily conference, why plain old boring bonds still belong in most portfolios. I conclude with some quick thoughts why complicated bonds, those with relatively big yields, do not belong in portfolios.
One reason to buy bonds is their growing scarcity. Diminishing supply supports bond prices and contributes to their use as a stable store of value. The US deficit is down and the government is selling less debt to finance the government. Same’s true for corporations. In the first quarter 2014 corporations sold $416 billion in bonds, a year ago corporations sold $1.14 trillion in bonds. Debt issuance for municipalities is the lowest since 2001.
A second reason is trouble in emerging markets. When there is political instability or market meltdowns in the rest of the world, investors flock to the stability of bonds in the United States.
A third reason is economic uncertainty at home. The economy is not out of the woods. GDP was just restated for the first quarter from a positive number to a negative one. If the second quarter comes in as a negative number as well, then we are, by definition, in a recession.
Fourth is an aging population. Baby boomers are retiring and looking for bonds to invest in, not stocks. This is not going to change for 20 or 30 years, as long as there are baby boomers.
Fifth is foreign governments are buying dollar-denominated bonds to cheapen their own currencies in order to stimulate their economies.
And one thinks of the experience of Japan, where interest rates have been punitively low for over 20 years. That’s what one must guard against here, especially if one is living off the income from his investments. So we think bonds belong in most portfolios. To be sure, the bonds should have a “ladder of maturities” so that every year something comes due, be of high credit quality, and be accompanied by a goodly portion of stocks that can adjust to changing economic circumstances (McDonalds can always raise the price of a hamburger). Over the years we have been careful to construct a ladder of maturities in our portfolios. And it’s really worked out. We would continue the practice now. Bonds won’t make you rich, but they are still a way to maintain income and preserve capital.
Other ideas to generate income include REITs, utilities and preferred stock, although these should not be used to the exclusion of old fashioned coupon bonds. They all contribute to diversification, which reduces risk.
One last thought on bonds. If a bond or a bond fund looks like it has an attractive yield, run the other way. It is an accident waiting to happen, for it relies on high amounts of leverage to achieve the yield. At the first sign of trouble, the yield will catapult the price of the bond fund in the wrong direction.