Stocks vs. Bonds: Why and When?
by Jason Brady
There are many different sources of information about the benefits and limitations of asset allocation.
Effectively, when individuals or professionals try to put together a portfolio, the question of “how much should I own of what?” is often a crucial first step. However, increasingly investors are focusing on goals beyond or in addition to total return. One of the tenets of modern portfolio theorysays that in a frictionless world (no taxes, transaction costs, etc.), investors shouldn’t care about the source of their return and that income (dividends, bond coupons, etc.) is the same as capital appreciation (price movement).
Portfolio Allocation and Income-Producing Investments
In the messy world of actually putting money to work in the marketplace, however, investors have generally moved beyond a world where individual assets are found along a so-called “efficient frontier.” Increasingly, investors are looking for solutions to specific problems, which may or may not include an asset allocation framework dictated by MPT. One of those problems is that of finding income. As demographics globally move toward a greater proportion of older individuals in developed markets, and expected life spans get longer, the need and desire for income-producing investments has increased dramatically. This is, in my view, part of the reason why many of those same developed markets have tiny “risk-free” rates of return. The income available from very low credit-risk instruments such as U.S. Treasuries and German bunds is at historic lows.
A growing body of theoretical and practical research also has highlighted the benefit of dividend-paying stocks as both an attractive total return option as well as a source of income return. Dividend-paying stocks tend to grow their earnings per share over time faster than non-dividend payers. This is quite counterintuitive (how is it possible to give away more, reinvest less, but then make more?), but is a key component to the overall strong returns of dividend payers over time.
Bonds and dividend-paying stocks share the significant advantage of having the tailwind of compounding income. While bond yields are low, even a small (but steady) income return compounds well over time. Investors tend to think of arithmetic returns, not geometric (compounded) returns, because multiplying decimals in your head is much harder and less intuitive than adding. As a result, the drumbeat of a solid income stream is often underappreciated.
But while there are significant advantages to income-producing securities, and a growing appreciation for that income, investors still confront what many consider a basic question: bonds or stocks?
There are many significant differences between these two asset classes, and we’ll detail them shortly, but I’d suggest that, at the end of the day, the name on the asset class (“Bond” or “Stock”) doesn’t capture the wide variety of potential investments, and it shouldn’t even be the first question that individual investors try to answer. Bonds come in a bewildering variety, from corporates to governments to asset-backed securities. There are municipal bonds that are federally tax-exempt. There are non–U.S. dollar bonds that add the complexity of a currency return to U.S. dollar–based investors. The investible bond universe is well over $65 trillion. To assume there is just one kind of bond is a fallacy that will hamper any investor’s potential return.
Stocks, too, have a wide variety of risk/reward profiles. Dividend-paying stocks are often considered somehow less risky than non-dividend payers. But in 2008, many dividend-paying sectors went down dramatically. So assuming that a dividend is enough to protect you from volatility will also lead to a poor investment experience.
The key is to remember that the best way to characterize any investment is to consider its individual merits, as opposed to classifying and pigeonholing every investment into a preconceived category.
Similarities and Differences
All this said, let’s consider at least some broad characteristics that many fixed-income investments share in contrast to equity investments: tax treatment, a maturity date and probable volatility (both up and down).
We’ve already mentioned tax-exempt “munis” that are a special category of fixed-income investments used to fund local and state governments, as well as some specific projects deemed to be valuable to those same governments. In general, however, the tax treatment of fixed income is worse than that of equities. Income from bonds is generally considered “income” as opposed to “dividends” or “capital gains.” In the current tax regime (which may, and probably will, change at any moment), dividends and long-term capital gains are generally given a lower tax rate than income. This can have a significant effect on an investor’s total, real return. Good tax advice may be more valuable to an individual investor than any amount of good investment advice that doesn’t take taxes into account.
The fact that bonds mature on a specific date is another significant difference between bonds and stocks. While stocks require a “greater fool” to sell and realize any investment gain, bonds mature. This can make a dramatic difference not only in the structure of the investment, but also in the psychology of holding it. Many investors used to tell me that if they don’t need to sell a bond, then they don’t care what the price is. I don’t hear that as often since the 2008/2009 fixed-income meltdown, but certainly the belief that you will receive the promised yield return makes investors hold on to fixed-income investments longer.
Because non-dividend stock returns are dependent on capital gains, a down trade in price for stock investors often seems more menacing than for bond investors. The smartest man I know, a good friend with an impeccable resume and several advanced degrees, exclaimed to me during the meltdown in 2008 that shares of Apple Inc. (AAPL) were cheap at $100 per share. As a computer science Ph.D., he had a very good working knowledge of their product set and believed strongly that they would continue their success. Not an avid investor, he said that he had bought stock.
A month or so later, as the ugliness in risky assets continued, he was upset about the performance of his stock. In fact, he said that as soon as the price returned to his purchase price, he would sell it. I of course urged him to either sell it today if he no longer felt that Apple was a good investment or hold it until he felt that the price reflected the value of the company (easy to say, very difficult to do—I’m not a great friend). Still, it was interesting to see an extremely intelligent person anchor his possible outcomes solely on his original purchase price, guaranteeing, at best, a flat total return on any investment that goes down.
In addition to the psychological impact, the difference in the certainty of the income return of each of these securities is significant. With bonds, the income return is guaranteed by the entity. If the entity does not pay, the bond is in default and usually the bondholder has some remedy against the entity. For example, if a corporate bond does not pay, bondholders have the right to force the company into bankruptcy, where they usually have the ability to take over the company. (This is subject to the priority of payments: Senior bondholders, have a higher claim than junior bondholders, who have a higher claim than equity investors, as is shown in Figure 1). With dividend-paying stocks, however, the question of payment is not just about ability to pay, but also about willingness. If a company does not wish to pay its dividend for any number of reasons, the stockholder has no remedy other than trying to sell the stock (usually then at a lower level, given that dividends are generally desirable).
The relative volatility and return asymmetry of bonds versus stocks is also an important differentiator. While there are clearly fixed-income securities that move in price quite dramatically (junk bonds were down as an asset class nearly 40% at one point in 2008, while 30-year U.S. Treasuries were up by the same amount), overall the volatility in bonds is significantly less than that in stocks. When prognosticators recently talked of a “bond bubble” as rates fell (and continued to fall despite many predictions of a dramatic increase), they intimated that investors would take large losses. However, most bonds are reasonably high quality, and so most losses would be more about opportunity cost and interest rate risk than complete loss of principal.
As an example, the most common index for U.S. bond investors, the Barclays Capital Aggregate Bond index, currently yields 1.87%. If rates were to move up about two percentage points (a very dramatic move and unlikely in the short term), with the Barclays Capital Aggregate index having a duration of 4.99 years, the index would lose approximately 10% in price (price loss = duration × rise in yield). The yield cushion currently available in the market is very low, so the income return of 1.87% over the course of a year would not do much to offset that loss, but an 8.13% loss is not catastrophic. This is especially true as the likely course of equities in this case (as part of a larger portfolio of both stocks and bonds) would be higher, as investors move out of the high-quality bond universe to take on more risk or economic conditions improve such that the Federal Reserve can raise rates and the prospect for equity investments is better. The point is that, as a whole, fixed-income returns generally move with less violence than equities. Higher-quality fixed income has recently moved higher in price when conditions are worse, providing a buffer for investors. Equities, on the other hand (along with low-quality fixed income), have moved lower in price as conditions worsen (as you might expect). This pro-cyclicality makes the volatility of the asset class doubly problematic, as not only do investors have to suffer large changes in price, but prices also move down just as investors are more vulnerable in other parts of their financial conditions.
This volatility paints a poor picture of stocks, but the flip side of that volatility is that stocks actually have significant upside, whereas bonds do not. With a portfolio of 10 stocks, half of those stocks can go to zero and the investor still has chance at a good, even great, return if the other five stocks more than double. In fixed income, if half of your portfolio has significant credit trouble, there is very little way that you can come out ahead, especially with current low market yields. So, in general, investors in bonds are making a trade-off versus investing in stocks. With a bond, the likelihood of a loss is lower, and overall volatility is also lower. However, if you have a loss, it’s very difficult to recover that loss with gains from the rest of your portfolio. This makes diversification in bonds that much more important.
Balancing Safety and Income
So, with some knowledge of the differences between stocks and bonds, how do investors create the best portfolio to generate income with some eye toward safety? Traditional asset allocation would suggest that with lower volatility and lower potential return, bonds play the role of ballast to a portfolio while stocks provide the potential for greater return with greater risk. On the income side alone, stocks today tend to pay a higher rate than fixed income (there are a number of company-specific examples of this in several sectors including telecom, financials and consumer staples), which furthers the thought that stocks are useful for performance and bonds are useful for balance. This income advantage for stocks was normal for most of the first part of the 1900s, and investors perhaps should demand more income return when there is uncertainty about that return, but nevertheless it increases the attractiveness of stocks in this low-yield environment.
Ultimately, though, the traditional single axis of risk/reward is far too limited in its analysis, especially given current market conditions. Because the traditional safe haven of high-quality fixed income (e.g., high-grade corporates, agency mortgages and U.S. Treasuries) has had a good performance history over the past 30 years, investors feel comfortable with that sector as “safe.” Equities, particularly emerging market and international equities, seem very risky.
But the traditional single axis of risk shown in Figure 2 does not take into account a number of risks that have been a big part of most investor’s experience.
One key example of a big risk to investors that does not show up in this concept of risk and reward is a possible inflationary scenario. Current Federal Reserve (and global central bank) policies are designed to stimulate demand in order to stem the possibility of deflation. Large government debt loads globally are going to be difficult to pay, especially if nominal prices decline. Remember that inflation is good for entities that are in debt (they pay off their debt with devalued currency), whereas deflation is a disaster (they have to pay off the same debt level with less income). Given high global debt levels, policymakers have a huge incentive to avoid deflation (although Japan over the last 25 years and other developed countries over the last three to four years have not been tremendously successful in this goal). If we get an inflationary environment, the risk to U.S. Treasuries and other forms of high-quality fixed income would be very high. Yields below 1.8% (nominal and pretax) do not provide a tremendous amount of cushion for an inflationary environment.
Stocks, in previous inflationary environments, have provided significantly better real returns than fixed-rate bonds, given that companies often have at least some power to raise prices and revenues in line with higher costs. While I don’t see a huge amount of inflation in the near future (in fact, recently reported prices in the U.S. have been notably lower), betting heavily on the Federal Reserve to be unsuccessful over the medium to long term is fairly risky.
And that risk is the point: If there is risk in something with the prospect of very little return (high-quality bonds), then the traditional view that those positions will save investors is insufficient. Even within stocks, we’ve already discussed that dividend-paying sectors in 2008 were some of the worst performers globally. In a “stagflation” world (low growth, inflation), growth equities may in fact be the least-risky asset class.
High-quality fixed income, even in an environment of low yields and some significant risk (from inflation or better economic outcomes), is not an asset class that investors should completely avoid. If riskier securities lose significant value, high-quality fixed income can help offset those losses, though I doubt there will be huge gains from here. But as an asset class in and of itself, it is hard to recommend strongly a group of bonds that are at all-time low yields.
The choice between stocks and bonds for income, or even for total return, misses the point that within those asset classes, the variation among individual assets is enormous.
In many cases, investors group “bonds” as a monolithic asset class [especially, oddly, in their 401(k) plans], despite the fact that there are huge variations between different bond investments in both risk and potential reward. Furthermore, the current low-yield environment engendered by global central bank policy has complicated the traditional risk/reward axis that holds that high-quality fixed income is safe and emerging market stocks are risky.
Investors need to know what they own, and why they own it and have a broader concept of where both risk and reward might come from.