Bonds: Weapons of Mass Capital Destruction

April 11, 2014— -- Despite the go-go stock market of the past year, a lot of money is still flowing into bonds, much of it from investors burned by the stock market meltdown of 2008.

Yet, as yields of good credit-quality corporate bonds are running about 3 percent, this just isn't a good way to make money. While nodding to these paltry rates, many investing experts nonetheless wax nostalgic over the glory years of bonds, starting in the 1980s and continuing into the 21st century. Back in the day, bonds were great, goes the logic, so they may be again.But few people in the industry are willing to recognize that, even during the glory years, bonds weren’t good enough to be better than stocks.

Sure, bonds can play a role of diversifying portfolios to the extent that their prices move in different directions than stocks’. But bond aficionados go further to claim that bonds help preserve capital, though just the opposite is true: They destroy it. So entrenched is the idea that bonds offer protection of investors’ capital that anyone who says otherwise is considered a heretic.

But history has shown that we should listen to and carefully consider those who advance unconventional views. In the mid-1800s, Ignaz Semmelweis, a Hungarian physician practicing in Vienna, was reviled for his view that maternity ward mortality rates were high because doctors were passing “morbid particles” to patients because they failed to wash their hand between procedures. (The existence of microbes had not yet been established.) The medical establishment, closed-minded by the misguided notion that gentlemen, especially doctors, couldn’t possibly pass along diseases, roundly condemned him. Semmelweis was ridiculed, deemed insane and committed to an asylum where he soon died after being beaten by guards.

He is now respected as a pioneer in hygiene. His name also lives on as an example of the folly of automatically rejecting beliefs simply because they run counter to established norms. Today, this automatic rejection of ideas just because they vary from what everybody “knows” is known as the Semmelweis reflex.

Reactions of the broad investment community to the suggestion that bonds aren’t good investments bring to mind the Semmelweis reflex. Such doubters should objectively consider facts of financial history pointing to the undeniable reality that bonds are weapons of mass capital destruction.

Bonds with high credit quality will always give you back the face-value capital you invested. The problem is that they destroy your purchasing power, meaning that this capital is worth less.

This was true even during the glory years. Let’s say that in 1984, instead of buying a Cadillac for $20,000, you put this money in a 30-year bond that paid 12 percent — what bonds were paying then. Today, at the end of the 30 years--and assuming the company that issued the bond was still in business--you would have received your $20,000 back, and along the way, you'd have collected $72,000. You'd have enough accumulated income to buy fully-loaded Cadillac, which now costs three times as much as it did in 1984.

But instead of buying the bond, let’s say you invested the $20,000 in an S&P index fund in 1984 (when stocks were considered wildly overvalued because of sharp gains over the previous two years). In the first year, you’d have received only about $800 in dividend income, but in subsequent years, the average annual dividend yield would have risen sharply, to well more than the bond’s annual $2,400 yield. What’s more, your shares in the fund, without any reinvestment of dividends, would now be worth more than $230,000 — enough to buy four loaded Cadillacs without dipping into the accumulated income from dividends.

If, during the glory years of bonds, you couldn’t get better capital preservation and protection of purchasing power than you would have received from large, dividend-paying stocks, why would you want to subject your capital to similar destruction in the inferior present-day bond market?

Those ready to send me to a funny farm, saying that I’m glossing over the risks of stock, should keep in mind that the index fund shares’ journey to this $230,000 value had a few bumps along the way, including a dip to $27,000 in the crash of 1987 and another from a rebounded value of $187,000 down to $85,000 in 2009. Yet, the shares finished strong in 2014 after giving our hypothetical investor increases in dividend yield in 28 out of the 30 years. Thus, stocks pose the risk of price volatility but not reduced purchasing power or income. By contrast, the $20,000 bond would have had less volatility but would have delivered the same yield every year — without a raise — while the price of everything increased.

Today, as interest rates have begun to creep upward (and will probably continue to do so at least for the next year), many people are skittish about these rates, fearful of getting trapped in bonds with long maturities. They’ll suffer a loss of buying power if they hold on to bonds that pay a lower rate than inflation, or they’ll take a hit when they sell these bonds in the secondary market. If you buy a 20-year bond today and interest rates rise 1 percent in the next 12 months, the buying power of your principal will drop 15 percent. To get that back would take five years of interest. Investment in new bond issues, with yields that reflect rising inflation rates, is another thing entirely.

Most investors believe that rising interest rates can always be expected to put downward pressure on the stock market, in part because during such periods, investors tend to seek the higher yields of new bonds.

Rising interest rates have signaled a falling stock market many times in the past — but not always. James Paulsen of Wells Capital says you can’t consider rising interest rates without also looking at consider confidence levels. When interest rates and consumer confidence have risen together, Paulsen has found, the stock market has almost always risen. Consumer confidence levels, now up substantially from where they stood during the recession, are rising, and there’s room for more growth; they are now still about 50 percent below their historical peaks. This means that people are in a frame of mind to spend money on the products of manufacturing corporations — a good sign for these companies’ stocks.

This scenario suggests a strategy of selling bonds and bond funds and buying stocks on dips — any dips. The alternative is to act like the other doctors practicing in Semmelweis’s hospital and ignore the evidence that bonds are weapons of mass capital destruction. Contentedly assuming that what everybody “knows” about the benefits of bonds is true, you could just sit there and embrace bonds while their fuses burn down to the explosives.

Dave Sheaff Gilreath is a founding principal of Sheaff Brock Investment Advisors LLC. He has more than 30 years of experience in the financial services industry, beginning with Bache Halsey Stuart Shields and later Morgan Stanley/Dean Witter. At Sheaff Brock, he shares responsibility for setting investment policy, asset allocation and security selection for the company's managed accounts. He also consults with the clients on portfolio construction. Gilreath received his Certified Financial Planner® (CFP) designation in 1984. He attended Miami University in Oxford, Ohio, where he earned a B.S. degree.

Any opinions expressed are solely those of the author and not of ABC News.