A Note on Bonds vs. Stocks

A Note on Bonds vs. Stocks

Understanding the nature of bonds and stocks will go a long way into assessing their appropriate roles as investible instruments.  This understanding is particularly important in today’s environment where low interest rates are coupled with inflationary pressure.

Bonds are debt instruments.  They are effectively loans to the federal government (government bonds), corporations (corporate bonds), state and local governments (municipal bonds), etc.  The big beneficiary of a bond is the issuing entity.  It is borrowing money and the interest rate expense is tax deductible.  Secondarily, in an inflationary environment, the issuer is making a fixed payment over time; consequently, it is paying in cheaper dollars.  On the other hand, the recipient of the interest payment is losing purchasing power and may be paying taxes on the income if it is a taxable account.  In today’s nearly non-existent yield environment, the income earned will not come close to maintaining purchasing power.  In fact, in the current inflationary environment, an investor is losing over 3% purchasing power with treasury bills and over 2% with 10-year treasuries (excluding tax considerations).  In other words, treasury bills protect the nominal value of the corpus while the 10-year treasury bill is vulnerable to rising rates, thus losses.  Neither provide much opportunity for growth or yield.

Many companies use debt to improve the value of their stock (equity).  Often when debt is issued the proceeds go toward buying back stock, thus increasing earnings per share (EPS) and the relative ownership of existing shareholders.  In those circumstances, the debt issuance benefits shareholders (the owners).  Also, when interest rates rise, which typically occurs in an inflationary environment, bond prices fall and the corpus declines in value.  The longer the maturity, the greater the impact on price and value for a given rate change.  The reverse correlation is true:  the shorter the maturity, the smaller the impact on price and value.  For this reason, shorter maturity bonds are often used to reduce the volatility of portfolios.

Another risk for non-government bonds is the so-called “credit risk,” which is the risk that the company or any other borrower defaults on the interest and principal payments.  In today’s environment, many investors are stretching for yield, and thus may be taking undue risk on lower quality bonds.

Stocks, which represent ownership in an enterprise, can provide cash to spend or reinvest through dividends.  Moreover, increasing cash flow which emanates from growth in the business provides for an increasing stream of dividends (cash).  In an inflationary environment, dividend growth typically rises at an even faster pace than inflation.  A bond, meanwhile, only pays a fixed amount.

It is all about the opportunity cost of money.  Currently the yield on the S&P 500 is at 1.33%, which is slightly below the yield on the 10-year treasury.  However, the dividend yield on the S&P 500 generally grows at a 5-6% rate per year.  Further, many higher quality stocks yield 2.5% or greater, a strong base from which to start.  In addition, from an historical perspective, the growth in dividends has exceeded the inflation rate by a wide margin.

Stocks are clearly more volatile than bonds and are more heavily influenced by the changing economic and public policy cycles.  Even so, an investor with a long-term view can benefit from the underlying growth of the U.S. economy and the stimulative policy biases.  Moreover, market corrections offer dividend reinvestment opportunities and enhance “recovery returns” which also benefit the long-term investor.

Another benefit to equity owners is that a company’s goals are aligned with the shareholders’ goals (the owners).  Many companies attempt to optimize their capital structure so as to benefit the owners.  In inflationary periods, firms often have pricing flexibility which allows for profit growth and an ability to maintain profit margins.

Focusing equity selection on developing and emerging themes and sectors with economic tailwinds offers the potential to achieve risk-adjusted returns.  Interest rates (particularly real interest rates) and the Fed’s policy posture play integral roles in the economic and financial market’s performance.  These key functions are important to monitor in attempting to assess market risk to achieve investment goals.  In the current interest rate environment, while not without risk (as with any investment), equities offer a greater return opportunity than bonds for the long-term investor.