Successes and Failures of Fixed-Income Investing - dummies

Successes and Failures of Fixed-Income Investing

By Russell Wild

In the year 1926, if somone had invested $100 in long-term government bonds, their original investment of $100 would now be worth $9,400. It grew at an average annual compound rate of return of 5.5 percent.

Even though you aren’t rich, $9,400 doesn’t sound too shabby. But you need to look at the whole picture.

Bonds beat inflation, but not by very much

Yes, you enjoyed a return of 5.5 percent a year, but while your bonds were making money, inflation was eating it away . . . at a rate of about 3.3 percent a year. What that means is that your $9,400 is really worth only about $765 in 1926 dollars. Your investment, in real dollars (inflation-adjusted dollars), actually grew 7.65 times.

To put that another way, your real (after-inflation) yearly rate of return for long-term government bonds was 2.4 percent. In about half of the 86 years, your bond investment either didn’t grow at all in real dollar terms, or actually lost money.

Compare that scenario to an investment in stocks. Had you invested the very same $100 in 1926 in the S&P 500 (500 of the largest U.S. company stocks), your investment would have grown to $298,000 in nominal (pre-inflation) dollars.

In 1926 dollars, that would be $24,300. The average nominal return was 9.9 percent, and the average real annual rate of return for the bundle of stocks was 6.7 percent. (Those rates ignore both income taxes and the fact that you can’t invest directly in an index, but they are still valid for comparison purposes.)

So? Which would you rather have invested in: stocks or bonds? Obviously, stocks were the way to go. In comparison, bonds seem to have failed to provide adequate return.

Bonds save the day when the day needed saving

But hold on! There’s another side to the story! Yes, stocks clobbered bonds over the course of the last eight or nine decades. But who makes an investment and leaves it untouched for that long?

Real people in the real world usually invest for much shorter periods. And there have been some shorter periods over the past eight or nine decades when stocks have taken some stomach-wrenching falls.

The worst of all falls, of course, was during the Great Depression that began with the stock market crash of 1929. Any money that your grandparents may have had in the stock market in 1929 was worth not even half as much four years later.

Over the next decade, stock prices would go up and down, but Grandma and Grandpa wouldn’t see their $100 back until about 1943. Had they planned to retire in that period, well . . . they may have had to sell a few apples on the street just to make ends meet.

A bond portfolio, however, would have helped enormously. Had Grandma and Grandpa had a diversified portfolio of, say, 70 percent stocks and 30 percent long-term government bonds, they would have been pinched by the Great Depression but not destroyed.

While $70 of stock in 1929 was worth only $33 four years later, $30 in long-term government bonds would have been worth $47. All told, instead of having a $100 all-stock portfolio fall to $46, their 70/30 diversified portfolio would have fallen only to $80. Big difference!

Closer to our present time, a $10,000 investment in the S&P 500 at the beginning of 2000 was worth only $5,800 after three years of a growly bear market. But during those same three years, long-term U.S. government bonds soared. A $10,000 70/30 (stock/bond) portfolio during those three years would have been worth $8,210 at the end. Another big difference!

In 2008, as you’re well aware, stocks took a big nosedive. The S&P 500 tumbled 37 percent in that dismal calendar year. And long-term U.S. government bonds? Once again, our fixed-income friends came to the rescue, rising nearly 26 percent.

In fact, nearly every investment imaginable, including all the traditional stock-market hedges, from real estate to commodities to foreign equities, fell hard that year. Treasury bonds, however, continued to stand tall.

Clearly, long-term government bonds can, and often do, rise to the challenge during times of economic turmoil. Why are bad times often good for many bonds?

Bonds have historically been a best friend to investors at those times when investors have most needed a friend. Given that bonds have saved numerous stock investors from impoverishment, bond investing in the past eight to nine decades may be seen not as a miserable failure but as a huge success.