Cash in Hand
Not the Time for Bond Shopping
If the drop in stocks has you considering a shift to "safety," then consider the risks that bond owners could face.
By Jeffrey R. Kosnett, Senior Editor, Kiplinger's Personal Finance
May 10, 2004
With the stock market having a bad run, you may be wondering if stocks will be kaput all summer, or if you'd be smart to cut back on stocks and go for something "safer."
Now, people ask me all the time what is safe. A 1% bank deposit where the interest is taxable and when inflation may be flaring up? Real estate securities when real estate is already high? Swiss this or Chinese that? I have to say, I really don't know.
Normally, the safest place outside of a bank is in short or intermediate-term U.S. government or municipal bonds. There's nothing wrong with a three-year Treasury now or a fund like Vanguard Short-Term Bond Index (VBISX), which has an average maturity of 2.7 years. The fund yields 2.6% and its share price is down only from $10.40 to $10.10 since mid-March, a period when the 10-year Treasury bond has lost 9% of its value and the yield is only now up to 4.8%. That's the highest a 10-year Treasury has been since mid-2002. But, on a historical basis, 4.8% is still not a high enough yield to tempt me.
But I don't think it would be a good idea to hunker down in short-term territory and make a huge bet on 2.6%, either. If being 70% in stocks and 30% in everything else was right March, then it's just as right now.
There are many explanations why the Dow Jones industrial average has sunk below 10,000 for the first time in six months. Oil prices and some Citigroup wrongdoing are easy explanations today. I suspect some on Wall Street are unhappy with the events in Iraq. None of this, however, stands as an invitation to go all-out bond shopping.
Repeat after me: Just because the stock market is sick doesn't mean bonds are healthy. Actually, looking ahead from here, bonds may fare worse. Why so?
First, the obvious: When interest rates and inflation rise, you know bonds will get hit. Stocks can fight off rising rates if the economy is strong enough to produce healthy earnings that support stocks' price-earnings ratios and other measurements of value.
In other words, while interest rate increases by definition harm bond prices, they are only harmful to stocks during a recession or when rates go dramatically higher. The Fed can raise rates a couple of times before it begins to choke business. The stock sell-off is discounting or anticipating the worst.
Second, the not so obvious: It's not like bonds are the only place to cushion risk of capital losses with income. Many companies have raised and will continue to raise dividends on their common stock, a trend connected both to higher profits and to the reduction in the top tax rate on dividend income to 15%.
The market is full of stable, defensive-type companies like big drug firms, consumer products giants (think Procter & Gamble) and well-managed heavy industry concerns (3M) that are performing very well and yield close to 2%, if not higher. To me, it's a no-brainer to choose between a 3M, with a 1.9% yield and even pessimistic analysts forecasting an 8% earnings gain, and a long-term Treasury bond whose yield is low on the face of it. It's no accident shares of 3M (MMM) and Procter & Gamble (PG) have fallen very little in the last few days of stock-market plunges.
Third, the dollar is again on the fence: That's worse for bonds than for stocks. This gets a little bit out on a limb, but think it through. Last week, the Bush administration asked Congress for a fresh $25 billion for the continuing cost of operations in Iraq. The financial world at some point will tire of lending money to the Treasury (translation: buying new U.S. government bonds) for this purpose at these interest rates when the return on this investment is unclear. A renewed fall in the dollar's exchange rate would likely send long-term interest rates higher than the Fed would like to see. It could also push the price of oil, historically quoted in dollars, into "a basket of currencies" or even euros. If so, holding a Treasury bond would get dangerous. But stocks can hold their position if business is okay. The 3Ms and Procter & Gambles can raise their prices and trade all over the world and earn profits in stronger currencies and translate them into more dollars. A Treasury bond cannot do this.
I can't say at what point bond yields would be high enough to get me excited. All I know is that we're not there yet.
Panic buying of stocks rarely works. The same is true of bonds.