Bonds Beat Stocks, But Uncertainty Dogs the Fixed Income Markets

Posted on Wednesday, May 16, 2012

By Charles Sandmel, AIF®, CFP®

Generally, bonds beat stocks in 2011.  High quality paper outperformed lower quality, and longer-term bonds beat shorter-term bonds.  Most of the nightmare scenarios that surfaced in late 2010 failed to materialize, although there were some bad scares.

  • The U.S. did not default on Treasury bonds.
  • Standard & Poor's downgrade of the U.S. credit rating hit stocks rather than bonds.  The yield on the 10-year Treasury note dropped from 2.88% to 1.88% between July 29th and December 31st.
  • The U.S. economy did not go into double-dip recession.
  • Europe postponed the day of reckoning for its economic, social and monetary crises-at the cost of austerity.
  • Municipal bonds did not experience widespread defaults.  Issuers adapted to financial constraint by reducing new bond issuance to a ten-year low.

The Barclays Capital US Aggregate Bond index returned 1.12% in the fourth quarter and 7.84% over the year.  By contrast, the S&P 500 returned 11.8% during the final three months of 2011, but only 2.11% for the year.

For the three years starting near the depth of the 2008/09 meltdown, the S&P (stocks) returned 14.1% per year while the Barclays returned 6.77%.  Within the bond universe, the US Government sector returned 9.02% and the US municipal index returned 10.7%.  High yield bonds, which had rallied with stocks through 2010, returned less than 5%.

We invest in bonds to generate income, preserve capital, and diversify the risks inherent in all-equity portfolios.  Last year's robust bond returns are largely attributable to price appreciation (bond prices and yields move in opposite directions), which is not the primary reason to buy bonds.  And both sides of that equation now make us cautious.

First, bond yields are very low by historical measures.  The " yield to worst" on the Barclays Aggregate Index yields 2.48%, and the longer municipal aggregate yields 2.82%, whereas the average dividend yield of stocks represented in the S&P 500 is 2.00%.

Second, the bonds in the indices are trading, on average, above face value.  This hinders capital preservation; if you buy bonds at the index average of $109, your return of capital at maturity (if held to maturity) will be nearly 9% lower than your investment.

The U.S. economy is in modest and tentative growth mode.  Inflation is currently under control due to weak demand, and the Federal Reserve has stated it will keep interest rates low through mid-2013.  Those factors imply stability and continued low bond yields for 2012. Expiring tax provisions next December present challenges.

Because there are so many uncertainties dogging the markets today, clients must be candid and current about their needs, expectations, and risk concerns.  We do not see a one-size-fits-all "case for bonds" today, any more than we see an overwhelming case for any other investment.  However, we would caution investors against cycling out of bonds today in the face of low yields, in the hope that they can get back in when the next bond market panic occurs (and there will surely be another panic sometime, somewhere). Such attempts usually result in poor performance.

Charles Sandmel is an Investment Advisory Representative of First Affirmative Financial Network, LLC. A 30-year veteran portfolio manager and past Director of the National Federation of Municipal Analysts, Mr. Sandmel manages fixed-income separate accounts for First Affirmative clients.

NOTE: Mention of specific companies or securities should not be considered a recommendation to either buy or sell that security.  For information regarding the suitability of any security for your investment portfolio please contact your financial advisor.  Past performance is no guarantee of future results.

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