{"id":3910,"date":"2013-05-16T12:22:03","date_gmt":"2013-05-16T19:22:03","guid":{"rendered":"http:\/\/www.wealthfront.com/blog\/?p=3910"},"modified":"2022-01-11T17:12:43","modified_gmt":"2022-01-12T01:12:43","slug":"bond-diversification-alternatives","status":"publish","type":"post","link":"https:\/\/www.wealthfront.com/blog\/bond-diversification-alternatives\/","title":{"rendered":"Sacrifice of the Bondholders"},"content":{"rendered":"

I<\/span>nvestors throughout the world have been flocking to so-called \u201csafe havens.\u201c The 10-year U.S. Treasury Bond has recently been trading at a yield between 1.5% and 2%. Short-term U.S. Treasury interest rates are near zero. Even if inflation stays at a 2% rate over the next decade[1]<\/a>, U.S. bonds will be a sure loser, providing negative real (after inflation) rates of return. If interest rates rise to more normal levels, investors will suffer substantial capital losses. Interest rates are also low in the center of Europe as well as in Japan. There are no \u201csafe\u201d economies where savers are able to earn positive real returns on government bonds.<\/p>\n

Most of the developed countries of the world are burdened with excessive debt.\u00a0 Governments around the world are having great difficulty reining in spending.\u00a0 The easier course of action as seen by politicians is to hold interest rates down to artificially low levels and hope that over time, inflation will erode the real value of the debt.\u00a0 The process is known as \u201cfinancial repression.\u201d\u00a0 It is a not-so-subtle form of debt restructuring and bondholders will be the sure losers.<\/p>\n

\n

We have seen this movie before in the United States, after World War II.<\/p>\n<\/div>\n

We know how bondholders will lose because we have seen this movie before in the United States.\u00a0 After World War II, the debt-to-GDP ratio in the United States peaked at 122% in 1946, even higher than today\u2019s ratio of about 100%. The policy response then was to keep interest rates pegged at the low wartime levels for several years and then to allow them to rise only gradually beginning in the 1950s.\u00a0 Moderate-to-high inflation reduced the debt\/GDP ratio to 33% in 1980, but this was achieved at the expense of bondholders.<\/p>\n

Double whammy: low interest rates, capital losses<\/h2>\n

Bond investors suffered a double whammy during the 1950s and later.\u00a0 Not only were interest rates artificially low at the start of the period, but bondholders suffered capital losses when interest rates were allowed to rise and new bonds issued were more appealing to investors than the old ones.<\/p>\n

Over the post-War period, bondholders received nominal rates of return that were barely positive and real returns (after inflation) that were significantly negative. We are likely to be entering a similar era today.<\/p>\n

So what are investors\u2014including those investors in retirement who seek steady income\u2014to do?\u00a0 I think there are two reasonable strategies that investors should consider. At Wealthfront, we employed both, implementing a new investment mix<\/a> that includes a more diversified mix of bonds and adds dividend-paying blue chip stocks.<\/p>\n

Investors can look for bonds with moderate credit risk where spreads over U.S. Treasury yields are generous. For example, government bonds issued by Australia and New Zealand have yields 1.5 to 2 percentage points higher than the bonds of the US government.<\/p>\n

\n

There are two reasonable strategies for investors to consider: diversifying their bond mix and adding dividend-paying blue chip stocks.<\/p>\n<\/div>\n

There are many countries in the world (including the fast-growing emerging markets) that have low debt\/GDP ratios, younger populations and excellent growth prospects.\u00a0 On the other hand, our aging populations in the United States, Europe and Japan are likely to lead to deteriorating fiscal situations. Many of the developing economies issue bonds with good credit quality and attractive yields.<\/p>\n

In addition, taxable investors should consider a portfolio of tax-exempt municipal bonds. The fiscal problems of state and local governments are well known, and the parlous state of municipal budgets has led to relatively high yield spreads on all tax-exempt bonds.\u00a0 Many revenue bonds with stable and growing sources of revenue sell at quite attractive yields relative to U.S. Treasuries.<\/p>\n

The second strategy is to consider using a diversified group of dividend-paying blue chip stocks (whose dividends have grown consistently over time) as an income-producing asset class. Many excellent companies have dividend yields that compare very favorably with the bonds issued by the same company.<\/p>\n

Blue-chip bonds vs. blue-chip stocks<\/h2>\n

An example is AT&T.\u00a0 AT&T common stock<\/a> has a dividend yield of almost 5%, about double the yield on AT&T 10-year bonds<\/a>.\u00a0 Moreover, the dividend from AT&T has grown at a 5% rate since 1985.\u00a0 While the growth rate of the dividend may moderate over the years ahead, it is difficult for me to imagine that investors won\u2019t be better off with telephone stock (and stocks of similar dividend growth equities) than they will be from bonds in the same companies.\u00a0 And if interest rates normalize, the volatility of a bond portfolio may be no less than the volatility of a dividend-growth portfolio.<\/p>\n

We are very likely to have entered an era that will be inhospitable for investors in many high-quality bonds in the world\u2019s developed economies.\u00a0 Fortunately, some reasonable alternative strategies exist for income-seeking investors.\u00a0 The traditional diversification advice of a simple stock-bond mix needs to be fine-tuned.<\/p>\n

\n

 <\/p>\n

\n
\n

[1]<\/a> \u00a0The informal target of the Federal Reserve<\/p>\n

 <\/p>\n

Disclosure<\/strong><\/span><\/p>\n

Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. Past performance is no guarantee of future results.<\/span><\/p>\n

 <\/p>\n<\/div>\n<\/div>\n","protected":false},"excerpt":{"rendered":"

Investors throughout the world have been flocking to so-called \u201csafe havens.\u201c The 10-year U.S. Treasury Bond has recently been trading at a yield between 1.5% and 2%. Short-term U.S. Treasury interest rates are near zero. Even if inflation stays at a 2% rate over the next decade[1], U.S. bonds will be a sure loser, providing […]<\/p>\n","protected":false},"author":65,"featured_media":7263,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"inline_featured_image":false,"footnotes":""},"categories":[1282],"tags":[1706,1302,1304],"coauthors":[522],"class_list":["post-3910","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-investing","tag-bonds","tag-diversification","tag-diversified-portfolio"],"acf":[],"yoast_head":"\nSacrifice of the Bondholders | Wealthfront<\/title>\n<meta name=\"description\" content=\"Malkiel suggests income-seeking bondholders consider investing in bond alternatives instead of government bonds from developed economies, US Bonds included.\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/www.wealthfront.com/blog\/bond-diversification-alternatives\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Sacrifice of the Bondholders | Wealthfront\" \/>\n<meta property=\"og:description\" content=\"Malkiel suggests income-seeking bondholders consider investing in bond alternatives instead of government bonds from developed economies, US Bonds included.\" \/>\n<meta property=\"og:url\" content=\"https:\/\/www.wealthfront.com/blog\/bond-diversification-alternatives\/\" \/>\n<meta property=\"og:site_name\" content=\"Wealthfront Blog\" \/>\n<meta property=\"article:published_time\" content=\"2013-05-16T19:22:03+00:00\" \/>\n<meta property=\"article:modified_time\" content=\"2022-01-12T01:12:43+00:00\" \/>\n<meta property=\"og:image\" content=\"https:\/\/www.wealthfront.com/blog\/wp-content\/uploads\/2017\/01\/stock01.jpg\" \/>\n\t<meta property=\"og:image:width\" content=\"1472\" \/>\n\t<meta property=\"og:image:height\" content=\"530\" \/>\n\t<meta property=\"og:image:type\" content=\"image\/jpeg\" \/>\n<meta name=\"author\" content=\"Burton G. 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