Burt "Random Walk" Malkiel on issues with a traditional stock bond allocation strategy

Wall Street Journal


December 7, 2011

The Bond Buyer’s Dilemma

In The Wall Street Journal, Princeton University economist Burton G.
Malkiel writes that the yields on long-term U.S. Treasury bonds will
likely fall below inflation for years, but fortunately some reasonable
alternative strategies exist for investors.

By Burton G. Malkiel

For years, investors have been urged to diversify their investments by
including asset classes in their portfolios that may be relatively
uncorrelated with the stock market. Over the 2000s, bonds have been an
excellent diversifier by performing particularly well when the stock
market declined and providing stability to an investor’s overall
returns. But bond yields today are unusually low.

Are we in an era now when many bondholders are likely to experience
very unsatisfactory investment results? I think the answer is “yes”
for many types of bonds???and that this will remain true for some time
to come.

Many of the developed economies of the world are burdened with
excessive debt. Governments around the world are having great
difficulty reining in spending. The seemingly less painful policy
response to these problems is very likely to keep interest rates on
government debt artificially low as the real burdens of government
debt are reduced???meaning the debt is inflated away.

Artificially low interest rates are a subtle form of debt
restructuring and represent a kind of invisible taxation. Today, the
10-year U.S. Treasury bond yields 2%, which is below the current 3.5%
headline (Consumer Price Index) rate of inflation. Even if inflation
over the next decade averages 2%, which is the Federal Reserve’s
informal target, investors will find that they will have earned a zero
real rate of return. If inflation accelerates, the rate of return will
be negative.

We have seen this movie before. After World War II, the debt-to-GDP
ratio in the United States peaked at 122% in 1946, even higher than
today’s 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.
Moderate-to-high inflation did reduce the debt/GDP ratio to 33% in
1980, but this was achieved at the expense of the bondholder.

Ten-year Treasurys yielded 2.5% during the late 1940s. Bond investors
suffered a double whammy during the 1950s and later. 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. As a result, bondholders received nominal rates of return
that were barely positive over the period and real returns (after
inflation) that were significantly negative. We are likely to be
entering a similar period today.


So what are investors???especially retirees who seek steady income???to
do? I think there are two reasonable strategies that investors should
consider. The first is to look for bonds with moderate credit risk
where the spreads over U.S. Treasury yields are generous. The second
is to consider substituting a portfolio of dividend-paying blue chip
stocks for a high-quality bond portfolio.

While long-term U.S. Treasury bonds are likely to be sure losers for
investors today, not all bonds should be considered bad four-letter
words. Let me provide two examples of classes of bonds where yield
spreads over Treasuries are reasonably attractive.

The first class is 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 very high yield spreads on all tax-exempt
bonds. Many revenue bonds with stable and growing sources of revenue
sell at quite attractive yields relative to U.S. Treasurys.

For example, the New York/New Jersey Port Authority gets reliable
revenues from airports, bridges and tunnels to support its debt.
Long-term N.Y/N.J. Port Authority bonds currently yield close to 5%,
and they are free of both federal and state and local taxes in the
states in which they operate.

High-yielding diversified portfolios of tax-exempt bonds are available
through closed-end investment companies. While these funds employ
moderate leverage, they provide yields between 6% and 7%. If tax rates
increase in the future, they will become even more attractive as

Another class of bonds that is attractive today is foreign bonds in
countries that have much better fiscal balances than we have in the
U.S. An example would be Australia, which has a low debt-to-GDP ratio
(about 25%), a relatively young population and abundant natural
resources, making its future economic prospects bright. Its currency
has been appreciating against the U.S. dollar. High-quality Australian
private bonds are available at yields of 8%.

Another strategy would be to substitute a portfolio of blue-chip
stocks with generous dividends for an equivalent high-quality U.S.
bond portfolio. Many excellent U.S. common stocks have dividend yields
that compare very favorably with the bonds issued by the same

One example is AT&T. The dividends paid on the company’s stock result
in yields close to 6%, almost double the yield on 10-year AT&T bonds.
And AT&T has raised its dividend at a compound annual growth rate of
5% from 1985 to the present.

The interest payments on bonds are fixed. If inflation accelerates, so
should AT&T’s earnings and dividends, making the stock perhaps even
less risky than the bonds. I am convinced that income-seeking
investors will be better served owning a portfolio of dividend-paying
U.S. stocks than they will be holding a portfolio of bonds in the same

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

Mr. Malkiel, professor emeritus of economics at Princeton University,
is the author of “A Random Walk Down Wall Street” (10th edition, W.W.
Norton, 2011).

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