Bold Ideas About Bonds and Cat Food for Thought

Two things you want to avoid as an investor: a lot of losses and a lot of regrets.

For instance, you don’t want to look back many years from now and regret having owned too much of an investment that earned you relatively little, and not enough of another investment that earned significantly more.

Of course, unless you get very lucky with the Psychic Friends Network, you can’t know in advance which investments will be the most lucrative. All you can do is make educated guesses based on the relative appeal of different assets, maintain a reasonable amount of diversification and hope for the best.

For many investors so far this decade, this stuff is still comfortably theoretical: We’re all “long-term” investors, so the risk of making a bad decision that returns to haunt you in 10 or 15 years seems hard to quantify now. But the day will come when the investment choices you make now may be all that matters--the difference, perhaps, between cat food and caviar on the dinner table.

Which brings us to a particularly bold pronouncement by Chicago-based investment firm Stein Roe & Farnham. Looking ahead five years, Stein Roe says long-term bonds will produce better returns over that period than blue-chip U.S. stocks--no matter what economic growth and inflation rates occur.

In the 17 years in which Stein Roe economists have judged the relative appeal of stocks and bonds, using varying economic and inflation scenarios, this is the first time bonds have won in every scenario, says Sandra Knight, a senior research analyst at the firm.

You think inflation will stay near current levels--about 2.5% a year--through 2001? That assumes moderate economic growth throughout the period, Stein Roe says. Under that scenario, the firm calculates that the total return (appreciation plus dividends) on the blue-chip Standard & Poor’s 500-stock index will average 9.75% a year.

But long-term Treasury bonds will do even better, the firm says, posting an average annual total return (appreciation plus interest income) of 11.5% over the period.

You think inflation will rocket over the next five years, averaging 6% annually over the period? Interest rates will rise, and bonds will post negative total returns (meaning your interest earnings won’t cover your principal losses), but stocks will do far worse, Stein Roe estimates: The S&P; index’s total return would be a negative 10.75% a year over the period, versus a negative 1.5% return, annualized, for long-term bonds.

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Other five-year scenarios, including one based on gradually rising inflation and another based on gradually declining inflation, produce the same outcome, Stein Roe says: Bonds do better than stocks.

How can Stein Roe economists know this? They can’t. They’re just making educated guesses. Given near-record-high stock prices, low dividend yields and Stein Roe’s estimate of the returns companies can earn on shareholders’ capital from here on out, the firm sees stocks’ appeal as subpar compared with the potential returns on long-term bonds at current yields--about 6.7% on 30-year Treasury bonds, up from 5.9% at the start of the year.

In other words, stocks are overpriced and bonds are cheap, Knight says. To fix the disparity, stock prices would have to plunge 25%, she says, or bond yields would have to tumble. Otherwise, buy bonds.

For many investors, however, the whole notion of choosing bonds over stocks is distasteful at best. Bonds are boring, and when they’re not boring, they’re absurdly volatile--as in 1994, when market interest rates soared, and 1995, when rates plummeted, and again this year, when they soared again.

Who needs that kind of volatility for annual yields of 6% to 7%, when the stock market can rocket 37% in a year, as it did in 1995?

There’s also the taxation issue: Bond interest income is fully taxable, while long-term capital gains--the major attraction of stock investing--are taxed at a maximum federal rate of 28%.

Let’s say Stein Roe’s stable-inflation scenario comes to pass and the firm is right about annualized bond and stock total returns of 11.5% and 9.75%, respectively, over the next five years.

Of that 11.5% bond return, 6.7% is interest income and 4.8% is capital gain. For someone in a 40% combined federal and state income tax bracket, that interest return is clipped to 4.0%, leaving bonds’ total annualized return at about 8.8%, before capital gain taxes.

Meanwhile, of stocks’ 9.75% return, only about 2.3% would be in fully taxable dividends. The rest would be capital gain. That would mean stocks’ total annualized return also would be about 8.8% before capital gain taxes. So bonds don’t look so superior after all.

However, adjusting for risk, and assuming your investments are in a tax-deferred account, bonds’ appeal arguably is restored under Stein Roe’s scenarios. Even so, many financial advisors say that doesn’t resolve other issues that detract from bonds’ long-term attractiveness relative to stocks.

James B. Fox III, a principal at money manager Clifford Associates in Pasadena, notes that stocks have historically provided inflation protection via earnings and dividend growth, while bonds remain completely vulnerable to inflation’s ravages because your interest return stays the same for the life of the bond.

(By Stein Roe’s calculations, however, rising inflation would exact a brutal toll from stocks over the next few years because investors would, at least initially, sharply lower the prices they’d be willing to pay for stocks in a higher-inflation environment.)

Moreover, because stocks involve higher risk than bonds, stocks’ returns should be above bonds’ in the long run, Fox notes, as indeed they have been. Thus, most investors should always keep most of their financial assets in stocks, he says.

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Bonds’ role in a portfolio, Fox says, remains the same as always: to provide higher current income than stocks (or money market investments) and lend “a modest level of stability” to an investor’s nest egg compared with owning stocks alone.

Depending on the amount of income and stability an investor wants, that means bonds should make up from 15% to 40% of a long-term portfolio, with stocks composing the balance.

Fox abides by some simple rules in directing clients’ bond investments. Stick with bonds maturing within seven years, he says, because yields generally aren’t that much higher on longer-term issues. And where possible, invest in individual Treasury, corporate or municipal bonds, not mutual funds--because with individual bonds you have more control and a set maturity date that in effect erases bonds’ volatility risk.

As for those glowing Stein Roe bond forecasts, if nothing else they may remind investors who now think only about stocks to consider how they might feel if, five years from now, it turns out that betting the ranch on equities was more a cat food than caviar decision.

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One View of Expected Returns

Investment firm Stein Roe & Farnham says that no matter how it figures the inflation scenario over the next five years, returns on long-term Treasury bonds beat stocks. here are annualized total return assumptions through June 2001 for stocks, bonds and cash (Treasury bills) under four inflation scenarios:

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Slowly Slowly Acute rising Stable falling inflation inflation inflation inflation Asset (6%/yr.) (3.5%/yr.) (2.5%/yr.) (1.5%/yr.) Stocks -10.75% -3.50% +9.75% +15.25% Long-term T-bonds -1.50 +3.75 +11.50 +17.50 Cash (T-bills) +7.75 +6.0 +3.75 +3.25

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Source: Stein Roe & Farnham