Let me introduce you to bonds–quick, before you go to sleep.
Bonds, alas, get no respect. To anxious boomers, stocks alone are the last best hope for building a retirement fund. You probably know by heart the data on total return: stocks, 10.5 percent annually since 1926; long-term government bonds, 5.2 percent (that’s capital appreciation plus dividends or interest).
The timing for bonds seems especially bad. The first lesson bond investors learn is that when interest rates go up, the market value of bonds goes down. And last week, headline stories opined that the Federal Reserve planned a rate increase to slow the economy’s boomy growth. Since the start of this year, when the latest rate rises began, funds invested in Treasury bonds have dropped 5 percent, according to Lipper Analytical Services. At the same time, the average stock-owning fund rose 7.5 percent.
So what am I, some kind of nut? Probably so. But here’s my nutshell case for bonds–Treasuries, corporates and municipals:
Bonds have been doing a whole lot better than the long-term average shows. Long-term Treasuries outdid stocks (as measured by Standard & Poor’s 500-stock average) in seven of the past 14 years, reports analyst Jim Floyd of The Leuthold Group in Minneapolis. Ibbotson Associates in Chicago finds that bonds yielded 12 percent to 15 percent in each 10-year period starting in 1980. Between 1982 (when the markets took off) and 1993, stocks gained 486 percent with dividends reinvested; long-term bonds gained 453 percent–almost exactly the same.
Historically, stock prices are high relative to bonds, making bonds a better value today. The high price shows up in the low yield you’re getting from dividends–just 2.2 percent of the average S&P stock price, the puniest ever. When bought at superlow dividend yields, stocks have historically earned roughly 5 percent a year over the following 10 years, says economist Burton Malkiel, author of “A Random Walk Down Wall Street.”
Earning just 5 percent from stocks can hardly be called a certainty. But it gets my attention. Ten-year Treasury bonds yield 6.9 percent today, quality corporates 7.4 percent and municipals 5.1 percent (equal to 7.1 percent in the 28 percent bracket).
The timing, for bonds, may turn out to be good instead of bad. “Consumers have run out of gas, retail sales are sluggish and home sales are slowing down,” says economist David Levy of the Jerome Levy Economics Institute in Mt. Kisco, N.Y. Even if rates bumped up a bit in the next couple of months, a slowing economy would eventually drag them down.
Which brings me to the second basic lesson on bonds: when interest rates fall, the value of your bonds goes up, sometimes a lot. Say, for example, that busi- ness stalls, and that rates on long-term Treasuries drop to 6 percent over the next 12 months, from a bit over 7 percent today. You’d earn a fat 21 percent, Floyd says. That might be hard for stocks to match.
And what if business barrels ahead? Interest rates would rise–maybe by as much as one percentage point. In that case, long-term Treasuries would lose 4 percent, Floyd says, but the rate spike would almost surely damage stocks even more. Rates up or rates down, bonds show more potential for gain, he thinks, and less risk of loss.
One final thing that new investors need to know: bonds don’t offer a steady ride. Since 1993, long-term bond prices have both risen and fallen 20 percent in a single year, says consultant H. Bradlee Perry of David L. Babson & Co. in Cambridge, Mass. Bonds often run in tandem with stocks but not always. If you own both, and average their performance together, you’ll have a more stable investment portfolio than if you own just one or the other.
For mutual-fund investors, bond funds seem the natural choice. They’re diversified; you can buy with modest amounts of money–$1,000 to $3,000, and much less in a 401(k); dividends are automatically reinvested; you can sell any time at the published market price. But because that price jumps around a lot, you can never be certain what your shares are going to bring.
If you want to live on the income rather than reinvest it, high-quality individual bonds may be the better choice. You purchase the bond for a fixed term; at the end you get your capital back, with little or no risk. You don’t notice the daily price fluctuations, so a losing month won’t scare you into selling out.
If you’re buying Treasuries, individual bonds make good investment sense. You don’t need diversification, so there’s no point in paying mutual-fund fees. But stick to bonds that you know you can hold to maturity–say, 10-year terms, not 30-year. If you sell before maturity, you can’t be sure of getting all your money out. To buy Treasuries without paying any sales charges, set up an account through the government program known as Treasury Direct (202-874-4000).
You might also buy individual tax-exempt municipals, as long as you stick to top quality. You can buy with as little as $5,000 (five $1,000 bonds), but it’s hard to sell such a small lot before maturity. Plan to hold for the duration and own at least five different issues.
Ginnie Maes are more easily handled in mutual funds (they’re mortgage-backed bonds with interest and principal guaranteed by the Feds). You benefit from automatic reinvestment, and from the manager’s expert choice of which bonds to buy.
Funds are also the smartest way of owning high-yield (junk) corporates. These bonds flourish in good economies. Since the start of the year, junk funds have gained 5.4 percent, while quality bonds have been flat to down. But junk declines when busineess does, so think of them more as stocks than bonds.
But think of them, and other bonds, too. The stock-besotted are losing touch with a genuine good thing.
