Sep. 21, 2009
As the Wall Street Journal has reported, many private investors have recently moved their assets into bonds: “At Vanguard Group, more than $51 billion has cascaded into bond funds this year. ‘It's been like Niagara Falls’ said Vanguard's head of fixed-income investing, Robert Auwaerter. Industrywide, investors sank over $40 billion into bond funds in August, an all-time high for a single month, and are on pace to break that record again in September.”
The main reason is, reports the Journal, that interest on money market funds or savings accounts have come a long way down. In the United States nearly 78% of taxable money-market funds, the traditional parking place for savings, are offering 0.1% or less in annualized yield, according to Crane Data LLC, a research firm. In Europe interest on money market funds or call-money is slightly higher.
But is it a good idea to move your assets to bonds or bond funds instead? Many investors are yet shying away from stocks – given the massive losses they had to endure in the crash bonds seem a save alternative to them. So let us look at the medium and long-term outlook for bonds and what it means for private investors.
A bond has two distinct advantages for the investor: Firstly, the expected interest earnings until maturity are known. Secondly, the consequences for any bond issuer who fails to pay the interest or pay back the par value of the debt are severe. For these reasons, bonds are usually considered less risky than stocks.
Extensive research shows that the average historic returns on bonds are significantly lower than for stocks. In the last 200 years, inflation-adjusted return for long-term government bonds (10 to 30 years) has been about 3% on an average. If you look at short-term bonds (below 10 years), the real returns come down to about 2%. Besides, the trend has been towards lower returns over the last five decades due to higher inflation. The returns on corporate bonds or government bonds in emerging markets may be higher, to compensate for a potentially higher risk.
The risk associated with a bond depends largely on the quality of the bond issuer. If you have a corporate bond, there is always a certain risk that the company may go bankrupt and fail to pay back the debt. Government bonds are usually considered safer (particularly governments of developed countries).
Another risk is inflation. If you buy a bond during a time of low inflation and the inflation rises during your holding period, all the interest and part of the principal may be eaten up by rising prices. This is one of the main reasons why the inflation-adjusted returns from bonds can be negative, even with a very long-term outlook. For a shorter-term outlook the risk associated with bonds is usually significantly lower than the risk associated with stocks because the interest earnings and re-payment are fixed in the case of the bond.
Especially the risk of inflation casts a shadow over the bond strategy today. The longer the maturity of a bond the higher the risk that a future inflation shock will bring heavy losses to bond investors. It is probably the best advice to investors to look for bonds with short maturity. Two years or a maximum of three years should avoid the worst losses if inflation is to raise its ugly head. The Wall Street Journal points out that “the riskiest bonds of all right now are Treasurys. If the economy improves and rates rise, they will get hammered. The longer the bond, the harder the hammering.”