Bonds retain appeal, despite rock-bottom yields
WASHINGTON (AP) — Bond yields are scraping along at record lows, but investors keep buying them, valuing the modest, fixed returns they pay over the bigger potential profits offered by stocks.
Bill Gross of PIMCO, perhaps the nation's best-known bond fund manager, declared last week that people should think long and hard before buying stocks at all. Gross said in a letter that "the cult of equity is dying." Investors have come to expect more growth from stocks than they can possibly deliver, Gross said.
Some strategists say they've seen this movie before, and investors are setting themselves up for disappointment if they avoid the stock market completely in favor of bonds. Profits from bonds are so meager, they say, that a portfolio of carefully chosen stocks would be a better bet than sticking only with fixed-income investments.
If you opt for bonds, "you'll never make more income than what the bond yield pays," says Margie Patel, managing director and senior portfolio manager with Wells Capital Management, a division of Wells Fargo. At least with stocks, she says, there's a far greater possibility that the value of the investment will appreciate, in addition to any income you may get from dividends.
For investors brave enough to ride out the market's current bout of volatility, "you'd do no worse on an income basis than with very conservative fixed-income investments," such as high-rated corporate bonds, Patel says.
As an example, consider a Microsoft bond due in 2021, which currently pays a yield of 1.6 percent. For every $1,000 invested in the bond, the holder gets $16 in income every year.
That's less than the income an investor would collect from dividends on Microsoft stock. Microsoft's dividend yield at current prices is 2.7 percent, so a $1,000 investment would generate $27 in dividend income every year.
Another point in favor of dividend-paying stocks: Companies are paying out a relatively low portion of their money in dividends, compared to historical averages, Patel says — about 28 percent of their available cash. As companies emerge from their recession-era bunkers, they will likely become less conservative about returning money to shareholders, she says.
In the case of Microsoft, the company has increased its dividend 15 percent over the past five years. Companies that raise their dividends routinely are more likely to continue doing so.
One big reason that bond yields are so low is the Federal Reserve. The central bank has bought trillions of U.S. government bonds and mortgage-backed bonds to keep interest rates low. By making safe investments and savings accounts less attractive, the Fed hopes to encourage banks to lend, people to borrow, and investors to seek higher returns in other assets such as stocks.
The yields on the lowest-risk corporate bonds tend to track the yield on the 10-year Treasury note. Investors believe the risk that a large, established company will default on its debt is relatively remote and doesn't change very much. As a result, the difference between the yield on that company's bonds and the yield on the comparable Treasury security — known as the spread — is relatively constant. When Treasury yields are low, corporate bond yields are, too.
Historically, when Treasury yields were higher, the yield on the 10-year Treasury note was better than the dividends paid by stocks in the S&P 500. Since 1970, Treasury yields outpaced S&P 500 dividends every month except for a brief period in late 2008 and early 2009, when companies had slashed their dividends and stocks were bouncing back from the worst of the financial crisis.
Until recently, that is. S&P 500 dividends blew past Treasury yields in seven of the 10 months ended June of this year, according to data from Birinyi Associates, a stock market research and money management firm.
Despite the slim returns available to bond investors, money continues to flow out of stock funds and into bond funds, according to Brian Reid, chief economist with the Investment Company Institute, a trade group representing money managers.
So why do investors continue to favor bonds?
Dan Alpert, managing partner of the investment bank Westwood Capital LLC, based in New York, says slow economic growth and even slower inflation make bonds attractive investments. When inflation is high, it erodes the purchasing power of bonds' fixed payments over time. When inflation is low, the opposite happens: the future payouts become more valuable.
The "real" yields on bonds — the amount they pay above inflation — are increasing, Alpert says.
Of course, there's no guarantee that stocks will go up. Despite her belief that investors are undervaluing stocks, Patel acknowledges that many still feel bitten by market crashes in 2001 and 2008, and by the herky-jerky trading of the past three summers.
Then there are the technological snags that have disrupted normal trading with increasing frequency. On Wednesday, a software glitch at the brokerage Knight Capital caused dozens of stocks to swing wildly as the market was flooded with erroneous orders.
Other recent market failures include the aborted initial public offering of BATS Global Markets in March, Facebook's chaotic first day of public trading in May, and the May 2010 "flash crash" that sent the Dow Jones industrial average down nearly 600 points in five minutes.
Even when markets are working properly, there are ample reasons for investors to worry about owning stocks. European policy makers have been unable to find a way out of their years-old debt crisis. Stocks fell sharply on Thursday after the head of the European Central Bank failed to announce new measures to bolster investors' confidence. If Europe experiences a major financial collapse and recession — still a real possibility — stocks could dive yet again.
Rob Leiphart, an analyst with Birinyi, says that adds up to fear among regular investors — enough to keep them away for some time.
"We've had the euro zone issues resurface three summers in a row, huge swings in volatility three years in a row, and people haven't recovered from the 2001 market yet," he said. "We just had a really bad decade."
But that's no reason to abandon stocks or bonds entirely, analysts said. Reid, of the Investment Company Institute, urged investors to "shy away from people who push them into dumping" one type of investment or another.
"Investors that follow an extreme investing strategy . . . are simply ignoring the risks of what they're investing in," Reid said.___
Daniel Wagner can be reached at www.twitter.com/wagnerreports.