As Stocks Face History, Many Pros Tout Bonds

Compared with the 1990s U.S. stock market, bonds seem dull, their returns paltry. To some novice investors, they even seem unnecessary. If stocks outperform bonds over time, who needs bonds?

The reality is that maybe stocks won’t outperform bonds over the time period that matters to you--not to mention that it is easier to make mistakes picking stocks.

And right now, some bearish Wall Street strategists and financial economists think bonds could outperform stocks for a substantial period.

“The real returns on risk-free assets [such as government bonds] are projected to be higher in the future than they have been over most of this century,” noted Wharton finance professor Jeremy Siegel during a recent UCLA Anderson School of Business conference on the “equity premium,” or the return that stocks historically enjoy over bonds.

Siegel and other economists have noted that bond returns are now higher than the “earnings yield” of blue-chip stocks--the expected earnings per share as a percentage of stock price, which is another way to express the price-to-earnings ratio, or P/E. (The earnings yield is calculated by dividing 100 by the P/E.)

U.S. stocks have earned a 7.1% real (after-inflation) annual average return this century, with an average P/E of 14.

But P/Es are much higher now. Economists say stock prices and earnings can’t be out of whack indefinitely and will eventually return to historical norms. Although profits are rising, they are not growing nearly as fast as P/Es.

Thus, the current blue-chip stock average P/E of about 30 seems unsustainably high, and the corresponding earnings yield--3.3%--makes current bond yields of 4% to 8% (depending on the type of bond) look good.

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Maybe structural changes in the markets and economy will justify high stock valuations, but no one can be sure.

Which is why many pros are touting bonds. Financial advisors like to keep a sizable chunk--maybe 20% to 30% of clients’ assets--in bonds or other “buffer” investments, things that are unlikely to go down when the stock market does, or unlikely to go down as much.

There are dozens of formulas for bond-stock allocation, most based on the idea that you increase the proportion of bonds as you get older.

Indeed, if you’ve built up a large stock portfolio in this decade’s bull market and you can live comfortably on what you have, you might even consider a virtually all-bond portfolio now, some experts say.

(Don’t confuse bonds with short-term “cash” accounts, such as money market accounts. Bonds are longer-term income-producing investments that generally earn much more than money market accounts over time. Money market accounts should be used for emergency money or cash that’s temporarily on the sidelines, waiting for an opportunity to be invested in stocks.)

The major risk bond investors face is that their fixed yields are vulnerable to higher inflation. Rising inflation eats away at bonds’ returns.

But individual bond portfolios can be designed to minimize inflation risk. This is done by mixing maturities, so that you always have some bonds maturing in the near future to invest at prevailing yields, which will be higher if inflation has risen.

If you choose to invest in bonds via mutual funds, you can mix maturities by spreading money over short-term, intermediate-term and long-term bond portfolios.

A more direct way to eliminate inflation risk is to buy inflation-indexed government bonds known as TIPS (for Treasury Inflation Protection Securities), now yielding about 3.85% more than inflation. These can be purchased individually or in one of a handful of mutual funds that specialize in them.

The Treasury reimburses TIPS owners for any increase in inflation along the way. These days, TIPS “are incredibly cheap insurance . . . to protect your purchasing power in retirement,” said Jay Ritter, a University of Florida finance professor.

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One key issue that keeps many investors from owning bonds is taxes: Bond interest income is taxed at regular-income rates, which can be significantly higher than the tax rate on stocks’ long-term capital gains. And many younger investors will argue that they simply don’t need the annual income bonds pay.

For that reason, many experts advise owning bonds within tax-deferred retirement accounts.

Another option: Own tax-free municipal bonds, which are issued by state and local governments. Munis are a particularly good deal for taxpayers in high tax brackets.

Times Markets Editor Daniel Gaines can be reached at daniel.gaines@latimes.com. He will moderate the “Strategies for Income-Oriented Investors” panel at 2:15 p.m. Saturday.

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At the Conference

The Times’ Investment Strategies Conference to be held May 22-23 at the Los Angeles Convention Center, features panels on “Strategies for Income-Oriented Investors” and “California Muni Bonds.” For registration information, call (800) 350-3211 or visithttp://161.35.110.226/sc