Here's a link to an important article entitled "Bonds' future fortunes are flagging," by Simon A. Lack, who is also the author of a recently-published book entitled Bonds Are Not Forever: The Crisis Facing Fixed Income Investors.
In the article, the author points out the many daunting problems facing bond investors today. Most investors are probably aware of the main problem: interest rates are at historic lows, as they have been for years, and have been held artificially low by the actions of central bankers (mainly the US Federal Reserve), and probably will remain artificially low in the foreseeable future. This drives down the income return for bond investors, and makes their purchases subject to the possibility of loss in market value when interest rates finally do begin to rise.
However, Mr. Lack's article articulates aspects of the situation which many investors may not fully appreciate. He explains that "Much of the return [for bond investors] of recent years has been fueled by capital gains through falling yields on long-term bonds" but that (as even the least-engaged bond investor should now realize) "Today's yields are close to, if not at, the point where further capital gain is not possible."
In the article, the author points out the many daunting problems facing bond investors today. Most investors are probably aware of the main problem: interest rates are at historic lows, as they have been for years, and have been held artificially low by the actions of central bankers (mainly the US Federal Reserve), and probably will remain artificially low in the foreseeable future. This drives down the income return for bond investors, and makes their purchases subject to the possibility of loss in market value when interest rates finally do begin to rise.
However, Mr. Lack's article articulates aspects of the situation which many investors may not fully appreciate. He explains that "Much of the return [for bond investors] of recent years has been fueled by capital gains through falling yields on long-term bonds" but that (as even the least-engaged bond investor should now realize) "Today's yields are close to, if not at, the point where further capital gain is not possible."
He then argues that bond investment returns from interest yields alone (without possibility of capital gains) "will turn out to be confiscatory" for three reasons:
1. Transaction costs for the retail buyer are now (and have always been) too high, with investors paying a markup representing "an unacceptably big chunk of the possible return."
2. Nominal yields on government and investment-grade credit will not stay ahead of inflation, let alone inflation plus taxes.
3. Even if yields were to stay ahead of inflation plus taxes, those planning retirement have to deal with costs which will rise faster than the measured "official" rate of inflation, and because they are generally on "fixed incomes" they will be even more vulnerable (unlike those who are still working and can hope to increase their incomes to keep up).
Again, these obstacles to bond investing are not new developments: the current situation has been building for over a decade, and many are aware of the general issue (although perhaps some of the nuances which Mr. Lack explains will reveal new sides to the problem for some readers).
The most significant aspect of his article, in our opinion, is the solution that Mr. Lack proposes for investors. While many professional investors who have recognized these long-term problems with bond investing have turned to all kinds of structured vehicles engineered to try to address the problems described above, and while individual investors are being sold all sorts of "alternative" investments supposedly designed to create stable income streams with "less risk," the article actually proposes something which we think makes more sense.
Mr. Lack asks: "So where should investors go in their search for more-reliable ways to preserve the purchasing power of their savings? The answer is equities. US common stocks come in many flavors, provide growth opportunities and also offer an extremely fair deal to investors in terms of transaction costs." Many stocks offer dividend yields that are much more attractive than the income possibilities of bonds, as well as offering attractive dividend growth rates.
To offset the greater potential for volatility (and even loss) which stocks present to the investor, Mr. Lack recommends holding greater percentages of cash than might otherwise be the case.
This strategy is actually one which we have been pursuing in our income strategy investing for some time, and we believe it is sound advice in the current environment. We believe investors should clearly understand these issues, the serious problems facing bond investors, and the different courses of action which are available to them in the situation that has developed over the past several years.
