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It's Time For Bonds To Get Some Respect

Personal Business: BONDS


What was a poor investment over the past sixty years will not necessarily be one over the next sixty. --Burton Malkiel, A Random Walk Down Wall Street

The investment gospel of the 1990s has been to stash your money in stocks for superior long-term performance. True, stock markets panic, crash, and tumble into bear markets. Yet since 1946, stocks have had average annual returns of 7.5% and bonds 1%, after adjusting for inflation. For the long-term investor, stocks have been diamonds and bonds zircons.

Will this long-term outperformance continue? Don't bet on it. The current surge in bond prices results from a powerful combination of economic and financial forces, including deflationary winds blowing from Asia. Historically, investors have done well with bonds when inflation is mute, and in the years following an especially exuberant stock market. With U.S. stocks up tenfold since 1982, perhaps it's time to consider changing conditions ahead and include a heftier portion of bonds in your long-term portfolio.

There is a strong short-term case to be made for bonds. The yield on 30-year Treasuries recently dipped below 5.75%, thanks in part to skittish investors seeking shelter from Asia's financial turmoil in default-proof U.S. government debt. Meanwhile, factories from Asia to the U.S. to Latin America are supplying the world with so many goods that price-cutting has become rampant. Central bankers in all the major industrial nations remain inflation hawks. Finally, U.S. productivity growth has accelerated, allowing the economy to run faster without triggering price increases. These forces will weigh heavily on interest rates--and sustain the current bond-market rally. "The 30-year bond yield will fall to 5% in 1998 and to 4% in 2000," predicts Edward Yardeni, chief economist at Deutsche Morgan Grenfell.

The current rally, however, is part of a broad trend toward lower interest rates that started in the fall of 1981. That year marks both the peak in government bond yields (at 15.78%) and the end of the great bond bear market that began in April, 1946. That era was marked by rising prices that culminated in oil shocks and an inflation explosion in the 1970s. Had a 2.5% Treasury bond been available throughout this 35-year period, its price would have declined from 101 to 17--or 83%, according to A History of Interest Rates by Sidney Homer and Richard Sylla.

BULL MARKET? It's possible that 1981 will go down as a similar milestone--the beginning of the great bull market in bonds. Bonds have done well whenever disinflation sinks deep roots in the economy. Already, the difference between stock and bond returns, what economists call the "equity premium," is narrowing (charts). From 1982 to 1997, bonds scored a real annual return of 9.4% and stocks 12.5%, according to Jeremy Siegel, finance professor at the Wharton School and author of Stocks for the Long Run.

But what if we have truly licked inflation? What if price levels 10 years from now are essentially the same as they are now--or even lower? That would surely shrink the equity premium further. Since bond returns are determined largely by inflation, investors able to ride out the inevitable tumult in the bond market should enjoy returns that nearly rival stocks. Says Siegel: "Virtually no economist believes the equity premium will be as high as it has been over the past half century."

Americans may even be in for a spell of falling prices. To many people, deflation is synonymous with depression, since the last time prices fell for any length of time was during the 1930s. Yet for much of the 19th century, prices fell, and the economy enjoyed strong growth. Between 1870 and the onset of World War I (the so-called Second Industrial Revolution), the economy expanded fivefold, real per capita income nearly tripled, and the U.S. emerged as the preeminent industrial nation in the world. A mass market evolved and the technique of mass production transformed industry after industry.

Inflation was negligible from 1870 to 1920, a comparable span to the period following World War II. Real bond returns averaged 3.4%. That's close to the 5.5% return for stocks, despite their higher level of risk. From 1870 to 1945, bonds returned 4% and stocks 6.7%.

BUDGET BOON. No matter how you slice the data, the message remains the same, says James Paulson, chief investment officer at Norwest Investment Management. "Stock and bond returns are close when inflation is not a worry."

It's not just the inflation outlook that favors bonds. The federal budget is poised to move into surplus in the current fiscal year. And bonds also tend to flourish following bouts of irrational exuberance in the stock market, according to a recent study by the mutual-fund company T. Rowe Price Associates Inc.

Stocks outperformed bonds by an average of nine percentage points annually in the five years ending in December, 1996. There have been six other five-year periods when stocks did better than bonds by nine percentage points or more. In four of the six subsequent five-year periods, the gap between stock and bond returns narrowed sharply. In the fifth case, 1965-1970, bonds outperformed stocks.

The case for bonds as a long-term investment is often underappreciated. At the same time, the stock mantra may be overstated. Sure, the fundamental insight informing modern finance is that returns are only earned as compensation for taking on risk. Stocks, a share of ownership in uncertain enterprises, are riskier than bonds, which are promises to pay back set amounts by a certain date. But what accounts for the big equity premium? A close look at the outperformance of stocks vs. bonds over the past half-century suggests a simple answer: Bold pioneers earn lush rewards.

In the 1950s, Wall Street was stuck in the doldrums even as the U.S. economy stirred and American business dominated world markets in autos, steel, and other mass-production businesses. Memories of the 1929 stock market crash lingered with the public and professional investors. Stocks yielded 7%, but the wealthy sought safety in bonds paying 3%, while the new middle class preferred putting money into banks and thrifts offering depositors 1.5%.

It was not obvious at the time, says University of Chicago Business School economist John Cochrane, that the U.S. would enjoy half a century of unprecedented growth. So intrepid stock investors were amply rewarded.

Yet there is another aspect to the motion of markets: Heady investment success eventually sows the seed of its own demise. Simply put, as the word about good fortune spreads, more people join in. Prices are driven higher and, eventually, returns shrink.

If you fast forward to 1998, you'll see that people have certainly absorbed the message that stocks are a good long-term investment. Twenty years ago, the amount invested in equity mutual funds totaled $34 billion. That sum has swelled to more than $2.3 trillion today as money has flooded into 401(k) retirement accounts. But are investors fully factoring in all the risks stocks entail? An environment of low inflation or even mild deflation is good for all financial assets, so stocks should continue to earn a decent return. But this same environment is nirvana for bonds. That's why they should do far better than their dismal reputation suggests.Christopher Farrell EDITED BY AMY DUNKINReturn to top

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