Letters

Bonds Yesterday and Today

Comment Posted to “A Balanced Approach: Less Risk, But Lower Potential Return,” by Stuart Ritter, CFP, in the December 2011 AAII Journal:

There is plenty of commentary demonstrating the risk-dampening effect of bonds. That is because bonds increase in value when stocks decline, largely because interest rates fall when the economy is suffering. However, my concern has to do with the situation moving forward. With interest rates at historic (and probably unsustainable) lows, it seems that bond investing is much riskier today and over the course of the next decade. Stocks may or may not rise, but it seems that interest rates have only one way to go, which would cause bond values to decline, perhaps sharply. Just food for thought: Is this commentary relevant, considering the bond market of today?

John from Texas

Stuart Ritter responds:

A couple of issues to keep in mind related to the reader’s points about bonds and the economic environment:

• Bond investors should consider total return, which reflects a bond’s yield as well as changes in price due to interest rate movements and changes in other risk factors.
• If interest rates rise, then total returns for high-quality bonds would be negatively impacted by rising interest rates.
• At the same time, if interest rates were to rise, perhaps in response to stronger-than-expected economic growth, then total returns for other types of bonds, such as high-yield or emerging market bonds, would not be as materially impacted by rising interest rates as their yield spreads relative to high-quality bonds would potentially compress in response to potentially improving economic growth prospects and the potential positive impact on credit quality.
• Therefore, a diversified fixed-income portfolio can also potentially perform well under a broad range of economic scenarios, although possibly underperforming U.S. Treasury bonds in an environment of slowing economic growth and falling interest rates.

It’s important to keep the above in mind when considering the role bonds play in a portfolio. Stocks and bonds don’t always move in opposite directions, and rarely by exactly the same amount. Historically, bonds have provided a lower average return with lower variability. Holding bonds in an otherwise pure stock portfolio has dampened the volatility an investor would otherwise experience—and this historical reality should still be taken into consideration when constructing a portfolio.

Magic Formula Shortcomings

Comment posted to the First Cut column, “Greenblatt’s Magic Formula,” by John Bajkowski in the December 2011 AAII Journal:

This is a nice summary of Joel Greenblatt’s book. I read the book, and there is very little to add beyond your article. I think this is a good shortcut to estimating company value. But I would hesitate to follow the investment advice. There are probably several reasons why this could be viewed as inadequate; I shall list two:

1. There is no decision threshold in this process, just the magic number 30. Presumably there are times when no company is a value play and it would be prudent to withhold from the market. There may be other times when many companies are selling at a good value. A decision threshold, or at least a guideline, would be useful in making the distinction.
2. In addition to a company being a value play, I am concerned about issues of debt (risk of bankruptcy and potential future interest burden) and persistent dividend yield (an additional measure of strength and durability). Adding Greenblatt’s formula to a short list of additional criteria seems valuable. Using it as a stand-alone omits a lot of valuable information.

Wesley from New Mexico