A HANKERING FOR THURSDAY

WHY BONDS ARE A BAD BET ?

Bonds are safe and a better alternative than those risky stocks, right? Don’t bet your future on it. For the last 20 years, bonds have outperformed stocks. That seldom-seen scenario has individual investors abandoning the stock market and pouring into bonds at an unprecedented rate. Like sheep to the slaughter, they haven’t bothered to ask themselves why bonds have outperformed stocks and whether that performance is likely to continue.

The boom in bonds has been fueled by two factors: A severe recession and an unprecedented drop in interest rates. When interest rates drop, the price of bonds rises. It’s easy to see why. If you buy a bond paying three per cent and the interest rate drops to two per cent, everyone wants to own your bond.

But before you sell everything you own and put it into bonds, consider this fact: The historic drop in interest rates is not only unlikely to recur going forward, it’s mathematically impossible for it to recur. That tells us one thing: bonds are highly unlikely to do as well in the next 20 years as they have in the past.

Keep in mind, too, that inflation is disastrous for bond prices. Should you be holding most of your assets in long term bonds during a period of high inflation, you’re going to get clobbered.

Does that mean you shouldn’t hold any money in bonds? No. Since the performance of bonds and stocks often diverges, it’s wise to hold at least a small portion of your assets in bonds or similar investments. But how can you do that without taking undue interest rate risk? 

Here are some strategies to consider:

1) Focus on the short term. If you’re attracted to the perceived safety of bonds, focus on short term issues. In the event that the bond market crashes, you’ll lose far less in these.

2) Alternatively, create a bond ladder. Buy bonds with a variety of maturities from short to long. If interest rates rise, you’ll lose on the long term bonds, but the short-termers will mature and allow you to reinvest the money at the new higher rate.

3) Try a no-load bond mutual fund. Research your options carefully. A good manager can help you spread your risk without the hassle of keeping track of your bonds yourself.

4) Don’t ignore other ways of diversifying your investments. Bonds aren’t the only alternative to stock market risk. With property prices bottoming and rents rising, a rental property can be a great way to get some diversification. If you don’t want the hassle of being a landlord, try investing in REITs (real estate investment trusts). Many of these trade just like stocks, but often rise when stocks are falling.

5) Seek safety in the stocks of large, stable, high-yielding companies. The dividend payout on many safe, stable companies is far greater than that on bonds. Unless you really believe the economy is going to get so bad that people will stop buying soup and toilet paper, consider these attractive alternatives to bonds. Be aware, though, that you’ll have lots of competition. When things look dicey, investors flood into these stable stocks and their share prices can soar. Look for a reasonable entry price.

6) Stay in cash until the picture is clearer. With returns so poor, you may be better off holding your money in an FDIC insured account where you can cash in at any time. When you decide which way the wind is blowing, you can decide how much to allocate to debt instruments.

Whenever the herd is pouring into an investment, it’s wise to think twice about following along. While bonds have done better for a longer period of time than most analysts expected, the party is almost certain to end soon. If you are convinced we’re headed for a long period of deflation, feel free to tie up your assets in bonds. Otherwise, look for better ways to deploy most of your investment funds.