Be Careful Buying Bonds

Thanks to two horrific bear markets, the 21st century has been wretched for stock investors. Meanwhile, bonds have continued to post solid returns with a lot less volatility than stocks. Warnings of higher interest rates have proved premature. And as bond yields have fallen in recent months, bond prices, especially those on long-term Treasuries, have climbed. Consequently, appetites for long-term bonds and bond funds have remained healthy.

Too healthy, in my view. This is a time for bond investors to exhibit utmost care. In view of today’s super-low yields, the product of a 28-year-long bull market in bonds, long-term-government bonds, as well as other long-term bonds, are about as risky an investment as you can make. Piling into bonds now is a really bad idea.

Let’s look back. The price of 20-year government bonds peaked in December 1940 after yields fell dramatically during the Great Depression. Over the next 41 years, the 20-year-government bond lost 67% of its value after inflation, according to data compiled by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School. (All returns in this article are after inflation, which has averaged about 3% annually since 1900.)

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By the 1970s, bonds had gained the derisive moniker “certificates of confiscation,” and deservedly so. A hapless bond investor who had the misfortune of buying in December 1940 wouldn’t have broken even until September 1991.

Since the end of that terrible bear market, bonds have had a tremendous run. From 1980 through the end of 2010, the 20-year government bond has returned an annualized 6.0%, not much less than the 6.3% return for the broad-based Wilshire 5000 stock index. Don’t bet on more of the same. “The golden age of the last 28 years cannot continue indefinitely, and we must expect returns to revert towards the mean,” Dimson and his colleagues write.

Reversion to the mean -- the tendency of returns to revert to their long-term averages -- is a powerful force in investing; ignore it at your peril. From 1900 through 2010, stocks returned an annualized 6.3%, far ahead of the 1.8% for bonds. What’s more, from 1900 through 1979, the 20-year-government bond returned an annualized 0.2%. Again, all these returns are after inflation.

What to buy instead of long-term bonds? Start with stocks. Just as every investor needs bonds in his or her portfolio, so everyone needs stocks. My favorite areas of the stock market today are large-company-growth stocks, which are unusually cheap compared with other types of stocks, and stocks in fast-growing emerging markets.

For large-company-growth stocks, my top choice is Primecap Odyssey Growth (symbol POGRX). It has 65% of its assets in health care and technology stocks. My favorite vehicle for investing in emerging markets is an exchange-traded fund, Vanguard MSCI Emerging Markets ETF (VWO). It provides exposure to a wide range of countries and companies at a low cost (0.22% a year).

Over short time periods, stocks are much riskier than bonds. After the 1929 crash, stocks lost 79% of their value after inflation and didn’t recoup those losses until February 1945. More recently, the stock market still hadn’t recovered fully from the 2000-02 bear market before the onset of the 2007-09 cataclysm. Despite the stock market’s rebound since March 2009, the break-even point for this century is still a long way off.

Because of the stock market’s volatility and short-term unpredictability, you should still own bonds. But I think this is a time to minimize the risk from rising interest rates. In other words, keep your maturities relatively short. I wrote about some bond funds that do that last month (see VALUE ADDED: Should You Dump Pimco Total Return?). But if you have ten years or more until you need your money, this is a time to load up on stocks and skimp on bonds.

It may not happen right away, but stocks are due to make up some lost ground. And putting money into long-term bonds is an invitation to trouble.

Steven T. Goldberg (bio) is an investment adviser in the Washington, D.C. area.