Commentary: Why Bonds Should Get More Respect

Stocks. Stocks. The stock market, it seems, has become today's answer to almost every money problem. Investing in your 401(k) plan? Stocks are the place to be. Setting money aside for medical bills when you get old? Buy and hold stocks for sure-thing, long-run superior performance. Saving for your kids' college tuition? Again, it's stocks. Nobel prizewinner Paul A. Samuelson likes to call the equity solution the "New Messiah."

The stock story appears compelling. With time, investing in equities isn't as risky as common lore holds, while the rewards are immense. According to numbers compiled by Ibbotson Associates, investing in the Standard & Poor's 500 equity index yielded an annual compound return of 10.5%, vs. 5% for long-term government bonds since 1926. Going back too far? In the post World War II era, stocks have outperformed bonds by an average of nearly seven percentage points a year. It's little wonder that bonds are anathema to many investors with long-term horizons.

VIOLENT DROPS. Yet the case for equities is oversold, while that for bonds is undersold. For one thing, the risks involved in the ownership of stocks are often glossed over. Remember when the stock market fell by more than 40% from 1972 to 1975? Says Peter L. Bernstein, an economist and fund adviser to endowments: "Experience tells you that the probability of doing badly is small, but that doesn't tell you how bad it may be if that small probability occurs." Stock market drops tend to be abrupt and violent, quite a problem for anyone retiring during a market storm. Yes, smart long-term investing is built on an equity base. But it makes sense to diversify into other assets--especially bonds.

Bonds are the Rodney Dangerfields of long-term investing. But recent history shows that they deserve better. Over the past 15 years, long-term government bonds have returned 12% and the S&P 500 16%, according to Ibbotson. In the 1990s, bond returns are running neck-and-neck with stocks--11% for bonds vs. 12% for stocks. And there is a sound reason for believing that bonds could draw even with stocks over the next couple of years--the continuing good numbers on inflation.

Indeed, there has been an underlying trend since the late 1940s for equity and bond returns to move closer together, argues Olivier J. Blanchard, economist at the Massachusetts Institute of Technology, in a recent paper. The long-term tendency toward convergence was interrupted by high and rising inflation in the 1970s, since inflation erodes the value of fixed-income securities. But convergence has resumed as inflation pressures eased during the late 1980s and 1990s.

Certainly, disinflation has put down deep roots in the U.S. economy, pushing bond yields sharply lower. "Bonds yields have fallen in half from the early 1980s. They could fall in half again and still be at about the country's 200-year average level," says James W. Paulsen, chief investment strategist at Investors Management Group Ltd. in Des Moines. "Disinflation took bonds from 14% to 7%, and no inflation might take them to 4%." The value of bonds would then soar--sweet news indeed for bond investors.

The inflation trend continues to improve. While the inflation rate typically accelerates by the fifth year of an expansion, this time it continues to fall. Labor costs remain remarkably subdued. The employment-cost index, which includes wages and benefits, rose by a mere 2.7% in the 12 months ending in September, the smallest yearly gain since the index was compiled in 1981.

The fundamentals suggest disinflation is here to stay. Tough international and domestic competition is keeping a lid on prices, as are price-conscious consumers. Strong productivity growth means the economy can grow faster without triggering inflation.

POTENT COMBO. The Federal Reserve Board and the central bankers of most other industrial nations are pursuing constrictive monetary policies. Fiscal policy in the U.S. and elsewhere in the industrial world is tight, as governments struggle to reduce budget deficits. The potent combination of tight fiscal and monetary policies means that "we'll have quite a long period of low interest rates," says Peter Buomberger, chief economist at the Union Bank of Switzerland.

True, the bond market is volatile. In 1994, bonds turned in their worst performance in decades. But this year, bonds have more than made up those losses, putting on one of the best showings in the modern era. And bonds should continue to shine. The 30-year Treasury bond could soon take a run at its record low of 5.89%, reached two years ago. Even that low rate could be a way station rather than a final resting place. Equities may still outperform bonds over time. But for now, it's going to be one heck of a race.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE