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April 07, 2008

No Bull? Bonds Can Trounce Stocks (and Beat Cash Too)
by Tom Madell

We have long argued that the great majority of investors under-utilize bond funds. Data suggest that at most only about 10-15% of the average investor's portfolio is usually kept in bond funds. Instead, many people stay invested in stocks regardless of how the economy is doing, as was the case for many people during much the 2000-2002 bear market. And if investors do decide to take refuge against a declining stock market, they usually opt for cash. Unfortunately, these investors don't appear to understand, nor appreciate, the value of bond funds especially during times of faltering economic growth and high levels of risk aversion as we have today.

This avoidance of bonds might make sense for people who are below 35 and have many years ahead to ride the ups and downs of stocks and still come out OK (hopefully, that is) in the long run. But once you are older than that, holding just stocks and cash alone may not be the wisest decision.

The last 10 years have been less kind to US stock investors than you might think, even though the span included more periods in bull markets than in bear. The average 10 yr. annual return for buy and hold investors in all diversified US stock funds has been a paltry 4.4% with likely even lower returns for investors who go with consensus thinking in attempting to time the market. Thus, anyone trying to save for the future on those kind of returns has not made much progress!

In spite of the emerging consensus that stocks may be set to climb from here on out, we are still in a negative period with many stock categories perched near a bear market, if not already in one. If your main alternative to stocks is just cash, then given we are also now in a time of falling interest rates, returns on cash are becoming smaller and smaller and more than likely to drop down to a 1 to 2% range! (Most rates for cash are currently less than 3%.) How good an alternative has cash been over the last 10 years? The average yearly return on money market funds and CDs has been roughly in the 3 to 3.5% range, thus not a useful alternative to the relatively poor performance of stocks over the same period.

Here's where bonds have proven a definite plus for those who have been able to see past all of the negative stereotypes and lack of understanding that discourage the majority of investors from bonds. One of my favorite and most frequently recommended bond funds is the PIMCO Total Return Institutional fund. Its buy and hold 10 yr. return has been nearly 7%. But even if this fund is not available to you since it is only for institutional investors, such as within certain retirement plans, other readily available bond funds have done nearly as well, or even better. Here are some of them: From Vanguard: Long-Term Treasury and Intermediate Term Treasury; from American Century: International Bond, and any of their "Target Maturities Trust" funds.

Additionally, by using some of the same strategies I have recommended for stocks, that is, by strategically identifying which categories of bond funds should be emphasized or avoided within a portfolio, it would have been entirely possible to do better that already nice 7% ("nice" as contrasted to the 4.4% alternative, or less, for US stocks).

Let's first do some basic data comparisons between bonds vs. cash.

We'll start by looking back over the bullish stock market period between 2003 and early 2007. The following table reflects my Model Bond Portfolio allocations made back in Apr. '03. (Click here to take a look.)

Note: The returns shown for Inflation funds are for Vanguard's Inflation fund since a category average is not available.

Note: The return for the Recommended Bond Portfolio is the return an investor would have gotten by investing in my Model Bond Portfolio and receiving the return of the average fund in that category.

The annualized returns from both my recommended portfolio or from the average US taxable bond fund after 1, 3, and 5 years were far better than the returns available from cash. The high degree of outperformance for bonds (and especially, my recommendations) over cash over these periods continuously resulted in a lot of extra money in the portfolios of bond investors over those 5 years.

As you can see from these results, and will see in the tables below, bond category results can be highly variable. So, it is not just an issue of whether one has bonds in their portfolio. Additionally, by correctly getting a sense of which bonds may outperform, one can sometimes do considerably better than the typical bond fund. Obviously, it will be hard to replicate the 12.4% outperformance of my bond portfolio during early '03 thru early '04 over one of the highest paying money market funds, Vanguard Prime, that we used in our cash comparison. Ditto for even our 5.2% outperformance over the average bond fund.

Now let's look at similar data for my Model Bond Portfolios over each of the years 2004, '05, and '06, followed by each Portfolio's comparative results. The data show our recommended bond allocations at the beginning of each year's 2nd Qtr. and each category's results after 1 year.

Note: Muni results adjusted to reflect taxable equivalent for 28% bracket.

These results show that during 2 of these 3 years, 1 year returns for our recommended funds and the average bond fund were better than for cash. The instance in 2005 that cash outperformed was only by 0.3% as compared to our recommendations.

Remember that all data shown above were during periods during which the stock market was in a bullish phase. So, while bonds almost always did better than cash, the absolute performance of the average bond fund was middling at best, and stocks were considerably better than either of the 2. Perhaps this is why many investors are mostly apathetic toward bonds; they correctly downplay their usefulness in generating returns during periods of good stock market performance.

But now let's see what happens when we look at 1 year bond fund returns during the stock bear market period between 2000 and 2002. We will then consider early 2007 up to the present and look at these recent results more thoroughly:

Once again, you can see that except for 2000, a transition year from stock bull to bear market, the average bond fund did better than cash. (Note though that by the end of 2002, an investment in the average bond fund made at the start of 2000 had again pulled ahead of cash.)

The data suggest that bond funds may be more consistent, relatively good performers during poor stock years than the sometimes good, sometimes bad bond results during stock bull years. But, even more significant during 2000-2002, is that bonds averaged over 17% per year better than stocks for 3 straight years. Such large outperformance would seem to make sense during periods in which while stocks sag, the Fed drops interest rates drastically trying to resuscitate the economy. This happened during the last bear market and is happening now.

Bond Performance During the Last 12 Months

Turning our attention to 12 months just past, a mixed period which started out with stocks still bullish but turning bearish just 6 mos. ago, it appears that bond returns reflect both the inconsistency of the bull period between early 2003 and early 2007, and the better performance during the 2000-2002 stock declines, as discussed above.

How well, in an absolute sense, have bond funds done over the past 12 months? Three categories have returned in double digits: Long Government, Inflation-Protected, and World Bonds.

Double digit yearly returns for any mutual fund, whether stock or bond, are always nice, but are particularly nice over the last 12 mos. when all US stock fund categories are showing negative returns, many double digit, except for natural resources and bear market funds.

Here is how my entire Model Bond Portfolio did over the last 12 mos. as compared to the average bond fund, the average US stock fund, and cash:

These results reflect both the poor bond returns at the beginning of the 12 mo. period and the relatively high return on cash before the Fed started drastically dropping short rates. (Please be aware that I alerted my subscribers to entirely eliminate High Yield bonds out of their portfolios in July before much of the damage reflected above had been done, although this damage has not been excluded in the above figures.)

Things have changed radically over the last 9 months. Many taxable bond funds, including most of the high quality types of funds we have recommended starting with my Oct. '07 Newsletter, have been returning in the area of 8% over the last 9 months, that is, 10-11% annualized.

What would you have earned over the past year in a money market fund (or a short-term CD)? A typical cash position, we estimate, would have averaged about 4.4%. But the longer interest rates are low (with money market rates certain to go lower soon), the worse these cash returns will be, and likely, the better the advantage bond fund returns will have over cash.

You should be aware that one of the reasons bonds have done reasonably well over the last 10 years is that we have generally had declining interest rates over that period. Like any other investment trend, things will not stay the same forever. At some point, interest rates will likely start to enter a long-term rising trend. At that point, bonds will no longer likely be as worthy an investment as they have been for the last decade. But until that starts to happen, the average investor should take advantage of the better returns that bond funds are continuing to offer as compared to merely holding cash. Generally speaking then, and overlooked by the vast majority of ordinary investors, bond funds can be an outstanding generator of healthy and steady returns during periods whenever the stock market is showing signs of continued negative or sideways returns.

Tom Madell, Ph.D.
Publisher
Mutual Fund Research Newsletter

Mutual Fund Research Newsletter is a free newsletter which began publication in 1999. It has become one of the most popular mutual fund newsletters on the Internet, ranking number 7 on the Google Directory page for Mutual Funds News and Media Newsletter websites. Since we began publishing our quarterly Model Portfolios, 29 out of the 36 Stock Portfolios have outperformed the S&P 500 Index over the following year (data as of Sept., 2009). Since 2000, 28 of our Model Stock Portfolios have had the opportunity for at least 3 years to pass since we first published it. 25 out of 28 of these Model Stock Portfolios have outperformed the S&P 500 Index over the following 3 years, and ALL Stock Portfolios (20 out of 20) have outperformed over 5 years as well. Mean level of outperformance has ranged from about 3% over 1 year to over 4% PER YEAR over 5 years.

Copyright © 2003-2009 Tom Madell

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