The following opinion piece by Burton G. Malkiel appeared in The Wall Street Journal on Wednesday. Dr. Malkiel is a world reknown economist who taught for decades at Princeton. His most popular book was the oft quoted "A Random Walk Down Wall Street". First published in 1973 in it is now in its 10th edition. I first read Random Walk in 1978 and it greatly influenced my outlook on investing.
The ‘real’ rate of return (bond return less inflation) on treasury bonds will likely be negative for years to come.
Other types of bonds will likely perform better.
Stocks that currently pay dividend yields in excess of corporate bond yields will likely offer inflationary protection.
The Bond Buyer's Dilemma
The yields on long-term U.S. Treasury bonds will likely fall below inflation for years. Fortunately, some reasonable alternative strategies exist for investors.
By BURTON G. MALKIEL
The Wall Street Journal.
Wednesday, December 07, 2011
Section A, Page 19
For years, investors have been urged to diversify their investments by including asset classes in their portfolios that may be relatively uncorrelated with the stock market. Over the 2000s, bonds have been an excellent diversifier by performing particularly well when the stock market declined and providing stability to an investor's overall returns. But bond yields today are unusually low.
Are we in an era now when many bondholders are likely to experience very unsatisfactory investment results? I think the answer is "yes" for many types of bonds—and that this will remain true for some time to come.
Many of the developed economies of the world are burdened with excessive debt. Governments around the world are having great difficulty reining in spending. The seemingly less painful policy response to these problems is very likely to keep interest rates on government debt artificially low as the real burdens of government debt are reduced—meaning the debt is inflated away.
Artificially low interest rates are a subtle form of debt restructuring and represent a kind of invisible taxation. Today, the 10-year U.S. Treasury bond yields 2%, which is below the current 3.5% headline (Consumer Price Index) rate of inflation. Even if inflation over the next decade averages 2%, which is the Federal Reserve's informal target, investors will find that they will have earned a zero real rate of return. If inflation accelerates, the rate of return will be negative.
We have seen this movie before. After World War II, the debt-to-GDP ratio in the United States peaked at 122% in 1946, even higher than today's ratio of about 100%. The policy response then was to keep interest rates pegged at the low wartime levels for several years and then to allow them to rise only gradually beginning in the 1950s. Moderate-to-high inflation did reduce the debt/GDP ratio to 33% in 1980, but this was achieved at the expense of the bondholder.
Ten-year Treasurys yielded 2.5% during the late 1940s. Bond investors suffered a double whammy during the 1950s and later. Not only were interest rates artificially low at the start of the period, but bondholders suffered capital losses when interest rates were allowed to rise. As a result, bondholders received nominal rates of return that were barely positive over the period and real returns (after inflation) that were significantly negative. We are likely to be entering a similar period today.
So what are investors—especially retirees who seek steady income—to do? I think there are two reasonable strategies that investors should consider. The first is to look for bonds with moderate credit risk where the spreads over U.S. Treasury yields are generous. The second is to consider substituting a portfolio of dividend-paying blue chip stocks for a high-quality bond portfolio.
While long-term U.S. Treasury bonds are likely to be sure losers for investors today, not all bonds should be considered bad four-letter words. Let me provide two examples of classes of bonds where yield spreads over Treasuries are reasonably attractive.
The first class is tax-exempt municipal bonds. The fiscal problems of state and local governments are well known, and the parlous state of municipal budgets has led to very high yield spreads on all tax-exempt bonds. Many revenue bonds with stable and growing sources of revenue sell at quite attractive yields relative to U.S. Treasurys.
For example, the New York/New Jersey Port Authority gets reliable revenues from airports, bridges and tunnels to support its debt. Long-term N.Y/N.J. Port Authority bonds currently yield close to 5%, and they are free of both federal and state and local taxes in the states in which they operate.
High-yielding diversified portfolios of tax-exempt bonds are available through closed-end investment companies. While these funds employ moderate leverage, they provide yields between 6% and 7%. If tax rates increase in the future, they will become even more attractive as investments.
Another class of bonds that is attractive today is foreign bonds in countries that have much better fiscal balances than we have in the U.S. An example would be Australia, which has a low debt-to-GDP ratio (about 25%), a relatively young population and abundant natural resources, making its future economic prospects bright. Its currency has been appreciating against the U.S. dollar. High-quality Australian private bonds are available at yields of 8%.
Another strategy would be to substitute a portfolio of blue-chip stocks with generous dividends for an equivalent high-quality U.S. bond portfolio. Many excellent U.S. common stocks have dividend yields that compare very favorably with the bonds issued by the same companies.
One example is AT&T. The dividends paid on the company's stock result in yields close to 6%, almost double the yield on 10-year AT&T bonds. And AT&T has raised its dividend at a compound annual growth rate of 5% from 1985 to the present.
The interest payments on bonds are fixed. If inflation accelerates, so should AT&T's earnings and dividends, making the stock perhaps even less risky than the bonds. I am convinced that income-seeking investors will be better served owning a portfolio of dividend-paying U.S. stocks than they will be holding a portfolio of bonds in the same companies.
We are very likely to have entered an era that will be inhospitable for investors in many high-quality bonds in the world's developed economies. Fortunately, some reasonable alternative strategies exist for income-seeking investors. The traditional diversification advice of a simple stock-bond mix needs to be fine-tuned.
Mr. Malkiel, professor emeritus of economics at Princeton University, is the author of "A Random Walk Down Wall Street" (10th edition, W.W. Norton, 2011).
Boudin Chaud. Cous Cous Froide. Allons Tigres--Poussez Poussez Poussez
Assistant State Treasurer
Chief Investment Officer
State of Louisiana
Department of the Treasury
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