Bond investment landscape looks gloomy

Better-than-expected economic reports have led to sharp movements in prices

Almost two years ago, I wrote an article published in NHBR titled, "A word of warning to bond buyers” (Dec. 2, 2011 NHBR). The article pointed out the risk in investing in bonds and why investors should consider investing in dividend paying stocks as an alternative. At that time, 10-year Treasury bonds were paying 2.4 percent and the market, as measured by the Dow Jones Industrial Average, was at approximately 12,100.

It turns out that my recommendation to reallocate long-term investment funds to dividend-paying stocks was a good call, since the Dow Jones Industrial Average recently reached a new peak and, as of this keystroke today, stands at 15,847. My warning about losses from holding or investing additional funds in bonds may have been a bit early, but investors this year have lost money in long-term bonds and bond funds.

Interest rates have moved higher, with the 10-year Treasury bond now yielding 2.67 percent.

With interest rates starting to rise, I believe it is important to amplify my warning about investing in bonds. For the first time since 2006, the Barclays U.S. Aggregate Bond Index has lost value — 0.12 percent in the first quarter of 2013, and 1.89 percent through the end of September. (The index tracks the broad market of bonds similar to the way the S&P 500 follows the broad market of stocks.)

These losses are expected to continue as rates are still historically low and more losses are expected as rates continue to rise. There is a long way for rates to go to get back to historical levels of around 4 percent for the 10-year Treasury bond.

The question on many investors' minds for much of the past year has been whether the 30-year bull market in bonds has come to an end. If the numbers show strength in the economy, then interest rates tend to rise and the value of bonds declines. This has lately been the case, as better-than-expected economic reports have led to sharp movements in the prices of bonds.

According to Bill Gross, the widely followed founder and co-chief investment officer of Pimco, the three-decade bull market in bonds ended in late April.

The dividend story

What is an investor to do? If one believes that interest rates will rise, then he or she should not have a large allocation of long-term bonds. According to Money magazine, long-term government bonds have lost 11 percent so far this year as rates rose. According to a recent column in Forbes, a one-percentage point rise in yield for long-term bonds will reduce their price by 17 percent, and a three-point increase in yield will cause a 41 percent price drop.

Earlier this year, Apple Inc. sold bonds to investors at a yield of 2.415% for 10 years and 3.883 percent for 30 years. These rates may be good for Apple, but really aren’t all that good for a savvy investor.

Although the stock market is near all-time highs, it may still be the best place to invest funds for the long term. It may be a surprise to some that many bond funds are now buying stocks in their portfolios to boost returns. This level of stock holdings in bond funds is the highest level in 18 years, according to a report in The Wall Street Journal.

From 2008 to the end of 2012, almost $1 trillion was invested in bonds, while more than $600 billion was withdrawn from stocks. It’s advisable not to wait too long to lighten up on or sell long-term bond holdings, as many others may be thinking of doing the same thing, especially with the losses being realized in many bond funds. Even FINRA (the Financial Industry Regulatory Authority), the largest independent regulator of securities firms in the U.S., recently posted a warning on its website to investors about the risk of investing in bonds at today's low interest rates.

Companies have been increasing dividends at a rapid pace in the past few years. Dividends in S&P 500 companies have increased 15 percent for eight consecutive quarters. The dividend payout ratio has only increased from 27 percent to less than 32 percent, meaning that companies are still earning a lot more than they currently pay in dividends. This growth in dividends is expected to continue, according to many analysts.

With corporate earnings continuing to remain strong, and with many well-managed companies having dividend yields greater than the yields on government bonds, stock investing still makes sense. If — or perhaps it would be better to say when — interest rates rise again, a diversified portfolio of dividend paying stocks will tend to outperform the equivalent investment in bond funds.

Daniel Cohen, CEO of Cohen Investment Advisors, Bedford, can be reached at 603-232-8351 or through investwithcohen.com.