To Bond Believers, Now Is a Good Time to Invest

Let’s say you’re handed $100,000 today and ordered by the generous giver to invest either in stocks or in bonds, but not both. The giver wants you to make money over the next 12 months. Which would it be--stocks or bonds?

With the equity market’s never-say-die rally this year, many investors would probably be inclined to go with stocks. Bonds, in contrast, just seem so . . . well, dull. The current annualized yield on a five-year Treasury note is 6.1%, and high-quality corporate bonds don’t pay much more than 7%. Meanwhile, the Dow Jones industrial average is up nearly 25% this year. No contest.

And besides, didn’t a lot of people lose more money in bonds last year than in stocks, when interest rates soared?

The public clearly is disillusioned with bonds and bond mutual funds, for some good reasons. But some money pros say that may be a classic “contrarian” sign that bonds are a better bet than stocks, at least looking out the next year or so.

One bond believer is Alfred Kugel, investment strategist at Stein, Roe & Farnham in Chicago. He’s convinced that the surprise in the global economy in 1996 will be that “we aren’t going to have blowout growth anywhere,” thanks to restrictive fiscal policies in most major countries (think Republican Congress) and to world central banks’ anti-inflation bias.

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That means the economic backdrop is going to be tougher for U.S. stocks, whose near-record heights may assume too much in the way of corporate earnings growth next year, Kugel says. In contrast, if a sluggish economy and low inflation allow interest rates to decline further, “it’s going to be good for bonds everywhere,” he says.

If you go with a five-year Treasury note at 6.1%, or a bond fund that invests in such “intermediate-term” securities (as opposed to longer-term bonds), you’ll earn that interest over the next year plus a capital gain if market yields fall further, boosting the value of older bonds.

Through August of this year, as market yields have slid with the weak economy, intermediate- term government bond funds earned a total return--interest plus appreciation--of 10.5%, on average, according to Lipper Analytical Services.

But what if Kugel is wrong and the economy and market interest rates zoom next year? That’s the worry that has kept many investors from buying bonds despite this year’s rally. Memories of last year’s bond market turmoil, as the Fed doubled short-term interest rates to slow the economy, are evidently still fresh. While investors have poured into stock funds this year, bond fund purchases have been minimal at best.

That has skewed the public’s fund holdings dramatically toward stocks--a reversal of the asset split between 1985 and 1993, when investors had more in bond funds than in stock funds. Today, stock fund assets are a record $1.15 trillion, up 54% from $749 billion at the end of 1993. Bond fund assets are $755 billion, slightly below the $761-billion total at the end of 1993.

“The longer [stocks’] bull market goes on, the safer people feel in the market,” notes Richard Dahlberg, director at Salomon Bros. Asset Management in New York. But he and other market pros fear that such complacency will end in disaster when stocks suffer a deep setback, which they will, someday. “We just think it’s time to look at diversification” using bonds, Dahlberg says.

Investors--particularly older ones--whose capital is totally dedicated to stocks should remember that while stocks undeniably perform best in the long haul, their short-term volatility can be harrowing. Bonds provide a capital-preservation element for a portfolio, helping to dampen overall volatility. Unfortunately, many people won’t know they needed that until it’s too late.

What about that 1994 bond market loss, as rates rose? True, bond values slumped. But the average total return on intermediate-term government bond funds, a negative 3.7% for the year, was hardly earth-shaking. Bonds’ prices may have dropped for a time, but at least investors were still earning interest all along.

If that’s the worst that can happen to bond fund holders in a year when the Fed doubles interest rates, how much trouble could bonds face in 1996 at current yields, even if the economy is stronger than expected? Not much trouble, Kugel suspects.

On the other hand, ebullient stock investors ought to be asking what their downside risk might be from these record price levels, either if interest rates rise next year or if Kugel’s forecast for weak growth and disappointing earnings comes true.

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Crazy for Stocks?

During the mid- and late-1980s bond mutual funds held more assets than stock funds, despite stocks’ generally superior performance. But the new generation of fund investors has gone hog-wild for stock funds over bond funds. Total assets of stock and bond mutual funds, in billions:

1995

Stocks: $1,153.2

Bonds: $755.3

Note: Data is for each year-end; except 1995’s, which is as of Aug. 31.

Source: Investment Company Institute