The Bond Fallacy

The bond bandwagon has gotten pretty crowded these days, with big names like Rob Arnott and Gary Shilling both writing that bonds — not stocks — appear to be the best long-term investment vehicle.

In his Return on Investment column for The Wall Street Journal, however, Brett Arends counters the arguments that the bond proponents (and in particular Arnott) have been raising.

“Obviously bonds, especially Treasurys, held up well during last year’s crisis,” writes Arends. “And they can make an important part of a portfolio, especially at the right price. But anyone hoping for a repeat of the last thirty years is probably dreaming.”

Arends says the bond return numbers are skewed because of the incredibly high rates that temporarily existed in the late 1970s and early 1980s — when some of the studies performed by bond advocates begin. Investors who bought long-term T-bonds in that period “simply pocketed an enormous one-off windfall when inflation collapsed,” Arends writes.

Back in 1980, inflation was close to 15%. Today, it is -0.4%. “Consider what that means for investors,” writes Arends. “In 1979, 20-year Treasurys yielded 9.3%. So over its life the bond paid out $180 in interest for each $100 invested. At one point in 1981, 30-year Treasurys yielded an incredible 15%, thanks to runaway inflation in the 1970s. Investors demanded high interest rates to offset the expected loss of purchasing power on their money.

“But when inflation collapsed after 1982, those coupon payments turned golden because the purchasing power stayed high. Bond prices soared in response. Today, bond investors get no such deal. Ten-year Treasurys pay just 3%. And the 30-year 3.96%.”

If sustained deflation occurs, bonds will do well, Arends says. But he also says inflation is just as likely as deflation, with the economy showing signs of life and the giant stimulus still to make its impact. Inflation, he says, would mean rough times for bond investors: “What would inflation mean for long-term bonds? The opposite of the lucky guy who bought long-term Treasurys in 1981 was the unlucky one who bought one in 1965, just before inflation began to surge,” Arends writes. “In 1965, a 20-year Treasury yielded just 4.17%. In the first year, the coupons on a $1,000 bond were enough to buy about 200 loaves of white bread. But by 1973 that was down to 151 loaves. And by 1980: A mere 80 loaves. The real return over the life of the bond was actually negative. … By the time [investors] got their $1,000 principal back in 1985, it bought only a third as much bread as the same amount would have bought in 1965. Even when you factor in the coupons, the investor ended up with less bread than if they had simply taken the entire $1,000 down to the baker’s in 1965. And notice we haven’t even counted the cost of taxes.”

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