Bonds: No longer a safe haven

They say that cowards die a thousand deaths—a morbidity rate exceeded only by the forecasts of market pundits. Third quarter results proved that rule once again. Despite many doom and gloom predictions, global markets had an outstanding quarter.

Is the shine coming off bonds?

In the U.S., large company stocks did well, rising 6.4% in the third quarter. International stocks did even better (+7.0%) and commo­dities did best of all (+9.7%).  Year-to-date, the S&P 500 leads all other asset classes (+ 16.4%), an amazing result considering the fiery fervor of presidential politics, the continuing controversy over Europe’s debt problems, and the fiscal cliff looming ever nearer on our horizon.

For those keeping score, the S&P 500, as of this writing, stands at 1468, up 110% from the nadir of the financial meltdown and about 9% below the index’s all-time high.

Investors pile into bonds, but shun stocks

Despite their strong performance, stocks still aren’t getting much respect. According to the Investment Company Institute, more than $77 billion dollars has flowed out of U.S. stock funds this year while almost $170 billion has flowed into bond funds. These year-to-date numbers continue a trend that has been in place for several years. Since 2007, $531 billion has flowed out of U.S. equity funds while $964 billion has flowed into taxable bonds.

After the 2008 drubbing in the stock market, I can understand why people might shy away from stocks. But before investors follow the lemmings off the cliff and into the bond market, they should consider that bonds may not be as safe as they appear.

Extreme levels. Has the Fed engineered another bubble?

Nominal yields on U.S. Treasury notes are at their lowest levels in modern history. With yields at theselevels, bonds pose significant problems for investors.

For example, with yields so low it is impossible for future bond returns to match historical returns.  In fact, based on our projec­tions, investors in the Aggregate Bond index are likely to earn less than 1.5% per year over the next ten years, and even that forecast requires heroic assump­tions about future interest rates.

A related problem is that today’s yields are below the rate of inflation—a condition referred to as negative real yields. Every dollar invested in bonds with negative real yields reduces the investor’s future wealth.

As significant as these problems are, our biggest concern for bond holders is their exposure to capital losses as interest rates revert to more normal levels. Bond prices fall as interest rates rise. The chart to the right shows the capital losses that will occur if interest rates increase by one percentage point. Of course, a move toward a more normal level of interest rates would likely be greater than one percent­age point, so potential losses could be much larger.

Given these concerns, we are currently in the process of reducing our exposure to falling bond prices. Our research has uncovered other opportunities that we believe provide greater protection and stability to our investors. If you would like to know more about these opportunities and how we are using them in your portfolio, please give us a call. We enjoy serving you and look forward to talking with you.