The One Sure Bet Today Isn't Stocks. It's Laddered Bonds.
Malcolm Mitchell - January 2003
(Click here for the full version [14 KB] in Microsoft Word)(Our thanks to Tim Aurthur and Larry Siegel for the data in the table below.)
Investors, you've had a great run in stocks these past eight years. The S&P500 has doubled, which means the annual return you enjoyed, including a few down years, was a solid 9%. The market may be 30% or 40% below its 1999 high, but you're still well ahead of returns from bonds. Don't worry about 2003, either. You'll stay ahead of bonds whether the market rebounds this year or just drifts. The long view still looks great from Wall Street, so come on down and profit with us.
Okay, that's not the talk today. Stock promoters have all announced their great expectations for 2003. But why? It is true that if the stock market only drifts in 2003, or even beyond, stock returns will still beat bonds on a long-term basis. Why is there so much effort to convince investors that this is the year when stock prices will surge once more?
There's a good reason. The mantra "Over time stocks outperform bonds" has one huge flaw: we only know it works if we're looking backward. No one is certain that stocks will outperform bonds from today on, no matter how long investors are willing to wait. Theories abound, but no law guarantees it.
Stock investors are like travelers who hop on a constantly-moving train, where they may be treated to sunny new scenes and collect lovely presents, as they roll toward an unknown destination. From time to time, however, the train enters a tunnel. The light disappears, the air becomes stagnant, and the presents start to disappear. The conductor then announces: "Folks, I don't really know when we'll exit this tunnel, but you needn't worry. Whenever we entered a tunnel before, we eventually came out." And he recites the previous tunnels, with the exits from each.
In the year 2000, stock investors entered a tunnel, but they were assured that the exit wasn't far off. In 2001 they were still in the tunnel but reassured of an imminent return to the light. In 2002, still in the tunnel, they saw their piles of presents, especially those of recently-boarded passengers, sadly diminished. Have investors started to wonder whether the ride is now different, whether there's something the conductor doesn't know or isn't telling them? Is their confidence flagging? Are more hands groping for the emergency cord?
They are, and stock promoters know it. That's why 2003 is so important to them. Wall Street is at fever pitch for a market surge this year -- even in the face of price/earnings ratios that are still far above their historic range (see "Only At the Right Price" on this web site).
Could 2003 be the year? Of course it could. We can't claim to forecast the future any better than anyone else. But asking whether the stock market could surge this year is, in our view, asking the wrong question. The right question is: Looking forward, is there a sure long-term bet for increasing my assets? And the answer is: Yes, U.S. Treasury bonds.
Professionals acknowledge that Treasury bonds are the ultimate dependable investment, the one means of ensuring that assets will always grow. Yet recommending them often triggers two negative thoughts: low returns, and inflation risk. We're going to describe a familiar Treasury bond strategy that protects against inflation; we'll then show that the strategy has provided impressive asset growth over time.
First, note that individual investors can buy bonds directly from the U.S. Treasury -- on line at www.treasurydirect.gov or by phone at 1-800-722-2678. No trading fees or any other fees are charged, and the Treasury will maintain your account with no management fee. Dealing directly with the Treasury can put you 50 basis points ahead of a typical Treasury-bond mutual fund. That's $5 more in your account -- annually -- for every $1,000 invested.
Here's the approach you can use; it is known as a laddered-bond strategy. Let's say you have $1,000 to invest this year. You buy a 10-year Treasury bond; the current yield is about 4%. At the end of the year, your account will show the bond at its face value -- $1,000 -- plus the interest you've received -- about $40.
Next year, when your first bond is a year closer to maturity, you invest $1,000 in a new 10-year Treasury bond. Now here is the inflation protection that this strategy offers. The interest offered on the new bond will probably be different from the roughly 4% paid this year. The difference will result from a number of factors, but the most important is inflation. If inflation is rising, you'll receive more than 4%; if it's falling, you'll receive less.
Over time, the strategy will keep up with changes in inflation reasonably well. In periods when inflation and interest rates are rising, the value of your assets may fall behind, because you already own bonds with lower interest payments. But you will catch up in periods of falling inflation, because all of the bonds you own will pay interest that's higher than the interest rates on new bonds.
At the end of the second year, your account will show $2,000 in face value for the two bonds you bought, plus $80 of interest (for two years) from the first bond and, let's say, $38 dollars of interest from the second bond -- a total of $2,118. What's important is that you will at that point own one Treasury bond that will be paid off in eight years (that is, you will then receive the face value of $1,000), and a second bond that will be paid off in nine years.
If you buy a third new bond at the beginning of the third year, you will then own bonds that will be paid off in eight, nine, and ten years. At the end of ten years, your portfolio will contain 10 bonds, one of which will be paid off in each of the following ten years. In the eleventh year, the first bond you bought will be paid off, and if you contribute another $1,000 to your account, you will have $2,000 (plus accumulated interest) to invest in a new 10-year Treasury bond. If you continue the strategy through 20 years, then with the same $1,000 of annual contributions you will be buying more than $3,000 of a new bond every year.
Using this strategy, your assets only grow, and they grow in real, that is, inflation-adjusted terms. The table below shows how assets using this strategy would have grown in the past. It also shows stock returns, measured on the same basis. Read the numbers carefully. The winner has clearly been stocks, but not over the past six years. And not by very large margins in recent periods.
And how about the future? What we know about a laddered bond strategy is that it will consistently produce real growth in assets. What we know about stocks in the future is that they may outperform bonds -- or maybe not.
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