In many conversations with clients who want to know more about how we construct our portfolio, questions about our feeling about bonds keep coming up. As we wrote in a recent post (Are bonds safer than stocks?), we have reduced the amount of bonds in our portfolio because, among other reasons listed, we find that bonds pose a greater risk than stocks in the current environment.
We’re certain that questions about bonds keep coming up because, as the conventional wisdom dictates, investors are advised to add bonds to their portfolios for diversification purposes. The idea is that, by combining uncorrelated assets (stocks and bonds), it would reduce portfolio volatility and risk. However, that doesn’t mean bonds are safer than stocks, just that the strategy of diversification can make your portfolio safer. But in their current state, bonds are much more of a drag on portfolio returns as they are diversifiers.
Looking at it from a pure risk-reward perspective, it just doesn’t make sense to own bonds at this time. Here’s how we arrived at that conclusion.
The Current State of Bonds
The bond market is primarily viewed through the lens of interest rates, which is the return investors get when they purchase a bond. Right now, bond yields are hovering around historic lows. The 10-year Treasury actually dipped below 1% for a brief period last year but has since risen to the 1.6 to 1.7% range. That’s still extremely low by historical standards.
So, when comparing investments in bonds or stocks, that becomes your reference point because it represents the total return to an investor who holds the bond to maturity. While other types of bonds that, depending on their risk, yield more than treasuries, the 10-year Treasury is considered a benchmark which is why we use it as the primary reference point.
With Equities, Follow the Return on Equity
When we look at equities, we understand that stock returns are tied to a company’s return on equity, which is why we believe return on equity is the critical measurement of productivity that drives investment returns. However, as investors, we only capture a portion of that return on equity, typically about two-thirds. For example, if a company’s return on equity is 15%, we could expect to earn a 10% return on our investment. So, for us, return on equity is the key benchmark and reference point for gauging the performance of a stock relative to the bond market.
Based on current economic production and current returns in the stock market, we are seeing returns on equity of around 13 to 14%. So, on a forward-looking basis, we are looking at two-thirds that, or around an 8.7% return on stocks. When you compare that with a 10-year Treasury return of 1.7%, there’s a significant return gap of around 7%.
Stay with the Margin of Safety
That return gap represents your margin of safety in stocks. In other words, if stocks were only returning 2% against a 1.7% return on treasuries, there is virtually no margin of safety, making bonds a more attractive investment. But as that margin increases in favor of stocks, it makes less sense to be in bonds.
Generally, if that margin is greater than 5%, it tilts the math in favor of stocks. If it shrinks below 5%, the allocation decision becomes more nuanced, involving consideration of other factors. It’s not just where interest rates are in an absolute sense. It’s where they are relative to the return on equity and expected investment returns that determine whether stocks are a good value.
You Can Never Say Never about Bonds
In the real world, two things can happen. One is that interest rates could rise, which would reduce that margin or constrain returns on equity, or both. Higher borrowing costs could also affect companies’ profitability. When these two things happen simultaneously, as they tend to do, you could see the margin shrink faster than it otherwise might appear, forcing another allocation decision between stocks and bonds.
In our estimation, the time horizon for something like that to happen, which would tip the scales in favor of bonds, is at least a few years away. But it is something we track closely because we don’t want to get caught by surprise. It’s better to anticipate and make portfolio adjustments gradually than trying to exit a crowded room that’s on fire.