Stocks vs. Bonds in a Low-Interest Rate Environment

It’s no secret that bond portfolios have outperformed stock portfolios through August of this year. Stocks have performed poorly as the economy weakened in the second and third quarters, while bonds have benefitted from investors reaching for yield and safety.

But what do you do today, when the 10-year U.S. Treasury bond is yielding only 2.5% per annum? I think that you favor equities and avoid long bonds like the plague.

Most client portfolios managed by BWFA are diversified among stocks, bonds, and other investments. The percentages of each are a function of the individual client’s risk tolerance and income needs. BWFA has different “risk models” that address these needs.

Our risk models assume that there is a negative correlation between stocks and bonds. As bond yields fall, the price of the bond rises, which helps to offset the potential decline in the value of the equities in the portfolio. But in a low-rate environment, this might not be the case. The closer that bond yields get to zero, the less protection the bond portion of the portfolio provides to offset potential losses in equities. (Yields will not go below zero, unless you are willing to pay someone to hold your money!)

To put it another way, the more yields fall, the more that risk becomes asymmetrical. The investor has a greater risk of losing money on his bonds as interest rates rise than he has potential gains if interest rates fall even further or the economy goes back into a recession.

For BWFA, the question comes to this: If you are going to take on this risk of losing 10% to 15% of your bond investments if rates rise, shouldn’t you be willing to take on the risk of owning equities, where you can participate in the upside if the economy improves?


Other Reasons to Favor Stocks

  • Stock yields are high. The dividend yield on a conservative portfolio of stocks is approximately 3%, as compared to 2.5% for 10-year Treasuries or less than 3% for short-term corporate bonds.
  • Bonds are the past year’s trade. Over the past 20 years, fixed-income securities have not outperformed equities two years in a row. Don’t bet on it happening now.
  • Corporations are buying equities. Cash-rich corporations with strong profits are either buying back their own stock or buying other companies.
  • Exogenous events that have hurt equities are being resolved. The markets have been beaten down by worries about the European (or developed world) debt crisis, the currency crisis, the BP oil spill, financial reform regulation, North Korean and Iranian nuclear ambitions, wars in Iraq and Afghanistan, and the expiration of the Bush tax cuts. As these issues are resolved (slowly) and the future becomes more certain, capital spending should pick up and spur economic growth.
  • Worldwide economic growth is stronger than in the U.S. Emerging markets, led by China, India, and Brazil, with growth rates of 5% to 8%, will help keep developed economies out of recession.
  • Stock dividends are taxed at a lower rate than bond interest. With the aim of keeping more after taxes, you really need to take a hard look at stock dividends.


A final note. BWFA is not recommending that you sell all of the bonds that you hold in a well-crafted portfolio of stocks and bonds. Most of the yields on bonds held in your portfolio are higher than current yields, and your bond portfolio will gradually mature over time. Therefore, if rates rise, you will have ample opportunities to invest at higher rates. But now is not the time to add to your bond portfolios. That opportunity is behind us.

If you would like to check your portfolio’s suitability for a low-interest-rate environment, please contact your investment advisor at BWFA.