Here’s How You Should Be Investing in Bonds Right Now

In last week's Wall Street Journal Burton Malkiel writes that investors should refuse to buy U.S. Treasuries and instead should buy Muni bonds, foreign bonds in countries like Australia that have better finances, and dividend paying stocks.

The reason I disagree with his recommendation to buy Munis is because they have credit quality risk that does not make them comparable to Treasuries. Also they have the risk of being refinanced into lower rates whereas Treasuries are non-callable (no prepayment allowed). Munis are thinly traded and subject to expensive Broker-Dealer markup-Markdown costs that are opaque and difficult to judge.

Australian bonds have the risk that if China’s economy cools then Australia will suffer a severe recession due to a drop in China’s demand for commodities. Some houses in Australia cost nine times what they cost at the beginning of the commodities boom a decade ago. So Australian bank bonds, mortgage bonds, etc. will be of poor credit quality during a commodity bust. The Australian crash will hurt the credit quality of their bonds making them go down in value.

Dividend paying stocks including utility stocks are not comparable with bonds and are not a substitute for bonds. Stocks have business risk that can result in dividend cuts or even bankruptcy. There is no such thing as a risk free utility stock. Remember Enron, or PGE? Remember the old ATT that lost a huge amount of money due to competition before being bought by SBC? What if electric power companies are required to meet tougher Green mandates that destroy their profits?

The idea that stocks are a “pass-through” for inflation “making the stock perhaps even less risky than the bonds” is wrong. During inflation people become poorer and react by reducing purchases, switching to lower cost (lower profit) vendors. Stocks don’t always go up with inflation. During the 1965-1981 inflation era stocks made no net price gains while the Consumer Price Index went up several hundred percent.

Stock bulls claim that low interest rates help act as a lever to raise stock prices, so that implies during a period of inflation interest rates will rise, increasing the discount rate for stocks and thus decreasing the price of stocks. Using stocks with a 3% dividend as a substitute for bonds is a dangerous game because the past twenty years the Fed has engineered an easy money bubble that has unjustly inflated stock prices beyond intrinsic value. Stocks can and will drop suddenly and mercilessly to a more reasonable value around 800 for the SP, a 37% drop and stay down for a long time.

The Purpose of Bonds

The purpose of bonds is to act as a safe haven rather than place to make a windfall. The haven is supposed to have minimal downside risk and thus can be liquidated during a stock crash and then used to buy stocks at low prices.

The way I could be wrong would be if I misjudged the recurrence of inflation and had too much in long term bonds. So one should be vigilant against inflation and maintain a bond portfolio with a duration that is medium to short term based their risk tolerance.

I understand that if we had a repeat of the 1970’s inflation then long term bonds would be badly hurt. Regarding inflation, in the past 220 years the only U.S. peacetime decade of significant inflation was in the 1970’s and that situation is unlikely to repeat. Instead, a Japan-style Soft Depression is the greatest probability. This would mean “risk assets” including the ones recommended by Malkiel will go down and Treasuries will go up in value.

About the author

Don Martin, CFP®

3 Comments

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  • Don, good article. I do agree that most Munis can be refinanced to lower rates but with rates at rock bottom now, isn’t this risk very small?

  • I’ve got a similar question as Tony. I’m with the Fed (about 10 years from retirement) and also currently have funds in C (~S&P 500 index), S (~DWCPF Index), and I funds (~EFA Index)….. about 60, 30, 10 split. Last year I was also 10-20% in the F (~LAG Bond index) but about March last year moved that over to C fund as I was worried that a rise in interests rates would give me a minimal or negative return in the bond fund (F fund). Funny thing is, very early in the year, I had considered moving everything over to F fund as I was worried about a large stock crash and so I wanted to protect my investment (dang I regret not doing that). So, given that interests rates can’t go any direction than up, isn’t it most likely that the bond fund is a bad place to be? Thanks.

  • Hi Don. Thanks for the Bond article.
    I have just retired from the fed. government where I am still invested the “Thrift Saving Plan’, (TSP). I currently have funds in all the five funds, The G, F, C, S and I funds.

    My question is, should get out of the F-fund (the treasury fund), completely, partially?
    I am seeing signs of a move away from treasury bonds. Thanks in advance.

    Tony

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