Investing has gotten really weird.
Illustration from “Through the Looking Glass.” Source: Ebbemunk
In today’s world the best performing assets are bonds. Bonds that have historically low interest rates continue to defy expectations. Ten years ago, bond guru Bill Gross famously declared that the great, multi-decade bond bull market was over. Since that prediction, long-term US Treasuries have returned 9% per year, while a cap-weighted index of global equities has returned about half that. And so far this year, bonds have zoomed up over 30%, while stocks have languished.
10-year returns. Source: Bloomberg
With coupons so low, people can’t buy bonds for income. What’s the point? A long-term US Treasury pays less than 2.5%. Over 90% of government bonds around the world pay less than 1%; more than a third have negative yields. The reason to hold bonds in the past was for diversification, and for the income they produce. That diversification has been quite profitable, up to now, as bonds have provided significant capital appreciation.
But where can investors go for income? Increasingly, they have been going to stocks. Triple-A rated Johnson & Johnson shares yield 2.6%. Exxon pays more than 3%. And telephone companies AT&T and Verizon pay more than 4%. The S&P 500 yields more than the 10-year US Treasury—and has done so for the past five years. Increasingly, investors own bonds for capital gains and stocks for income.
This is backwards. Companies pay dividends when they generate more cash from their operations than they can deploy profitably within their business. By definition, the dividend payers’ prospects for growth are limited. Bonds appreciate in price when interest rates fall. But rates are now so low that a buy-and-hold investor in many markets is guaranteed to lose money. And stocks can cut their dividends, as the S&P 500 did from 2008 to 2010, and as energy companies have for the past year.
Negative 5-year government bond yields. Source: Bloomberg
In “Through the Looking Glass,” Lewis Carroll has his main character, Alice, talk with Humpty-Dumpty sitting on a wall. Humpty-Dumpty loves to play word games. In the midst of a discussion about the meaning of a word, Humpty says, “When I use a word, it means just what I choose it to mean—neither more nor less. The question is, which is to be master?” Today he might say that when he chooses an investment, it functions just the way he wants it to. If equities are to provide income and bonds capital gains, who’s to argue? It’s worked for him so far.
But markets have a way of reasserting themselves. Never forget that bonds and stocks are financial instruments, and represent senior and junior claims on the cash flow of the global economy. Eventually, markets will adjust. When they do, Humpty-Dumpty—and unbalanced investors—will likely fall off the wall. We need to be prepared—through careful portfolio construction and proper diversification—to pick up the pieces.
Douglas R. Tengdin, CFA
Chief Investment Officer