Bond Ambition

By DAVID MOON, Moon Capital Management
October 24, 2004

A young professional recently moved almost his entire portfolio to long-term bonds. This guy has an extremely high income and no immediate need for any of his personal investment assets. He can't even touch his retirement plan for another 17 years. This is the type of person who is typically and appropriately invested very heavily in stocks. Yet out of fear about stocks, war, oil prices, the election, Tennessee's defensive backs or something similarly unpredictable, this individual abandoned the asset class which gives him the greatest opportunity to significantly outpace inflation, particularly over his working lifetime. Instead, he is invested almost exclusively in bonds ' an asset class selling at an almost 22-year high price.

Many of the risks of long-term bonds are completely misunderstood. Because interest rates have done little but decline over the last two decades, many investors and advisors have never experienced a bear market in bond prices. It is a foreign concept.

If you're concerned about the stock market, it is difficult to get excited about the paltry returns in CDs and money market funds. So some people gravitate to something that feels more stable, more safe: long-term bonds.

As unpleasant as it might be, imagine that the stock market is in the midst of one of its worst ever ten-year periods. Worse than the crash of '87 or during the oil embargo of the 1970s. Worse than during the days of hyperinflation or the misery index. Assume that only during the ten years beginning with the Great Depression did stock prices perform worse than they are during this current decade.

If the Dow Jones Industrial Average (DJIA) is still sitting around 10,000 when 2010 rolls around, it will be 16 percent below its peak of 11,908 in January 2000. Even with this negative assumption, a $100,000 investment in the DJIA today would still be worth $100,000 in six years. Adding its current 2.4 percent dividend yield, you would have $114,400. (In real life, you would also be able to reinvest the dividends and bond interest at some return, but I'm trying to simplify this as much as possible. The conclusion wouldn't change, however.) Not great, but how does this compare to how a $100,000 investment in bonds might perform?

The current yield on a 20-year Treasury bond is 4.8 percent. Do you think rates will stay this low forever? Probably not. If in six years the yield on the 20-year Treasury increases to only eight percent, the value of those bonds would decline to $73,000. You would collect almost $29,000 in interest payments over the six years, bringing the total value of your investment barely above the original $100,000. And unlike with stocks, you have little chance of capital appreciation.

It is perfectly reasonable to be wary of the stock market. But don't let caution cause you to make an emotional, wholesale move to an asset class that poses its own set of risks ' most of which are misunderstood.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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