Bonds may outperform stocks in the next 10 yrs

I figure that after my last post on stock market returns for the next 10 years, I’ll try and do something similar for bonds. After all, these are the two most important assets classes that make up retiree portfolios, often in the much talked about 60%/40% stock, bond allocation. Without taking a crack at this you can’t forecast portfolio returns over the next 10 years. Here it goes.

In a way I thought this was a much easier task than forecasting stock returns. Turns out that its proven more difficult. There is a lot more written about future stock returns than future bond returns. You practically can’t go a day without reading something about future stock returns. For bonds it seems to be different. At least right now, all the talk is about the presumed bond market bubble. There’s almost an article a day about the bond bubble. And there are tons of articles about interest rates, will they fall even more, when/if will they rise, etc…but nothing about forecasted returns for maybe the most important asset class of all – the bond market happens to dwarf the size of the stock market.

Maybe its because in a way its really easy to forecast bond returns. Take the 10 yr US Treasure Note yield, about 2.4% as of Friday, assume an investor holds the bonds to maturity, and that’s it. The 10yr return would be 2.4%/yr. Simple. Actually, no. That 2.4% yield is only accurate for a 10yr zero-coupon bond. The 10yr note is a coupon bond, it pays interest every 6 months, thus you need to consider re-investment risk. Only if interest rates stay flat for 10yrs will the return of the 10yr note be equal to the zero coupon bond. There is a better way I think.

Just like the SP500 is representative of the stock market, a portion of it anyway, we can use a bond index akin to the SP500 for stocks to do a forecast. I think the Barclay’s Aggregate Bond Index (AGG), oops almost typed Lehman’s, is the best proxy for the US bond market. It includes short term bonds, intermediate, long bonds, corporate, and gov’t bonds. Here is a snapshot of AGG’s characteristics from Morningstar:

The important stats to start off with are AGG’s current yield, 3.54%, and the duration of the portfolio, 4.1yrs. Duration is a measure of the bond portfolio’s sensitivity to interest rate changes. In this case, a change in interest rates of +1% would cause AGG to lose 4.1% of its value. Now, in order to complete the forecast we need to forecast a change in interest rates over the next 10 years. The forecasts for interest rates are all over the map, there is the deflation camp, and the hyperinflation camp, at the extremes. I’m more on the deflation side, basically I agree with Dave Rosenberg/John Hussman/Gary Shilling/Lacy Hoisington, but I like to forecast conservatively. For my forecast I will use a rise in interest rates of 2% over the next 10 years.

The result of AGG’s current 3.54% yield, a portfolio duration of 4.1 yrs, and a 2% rise in interest rates, is a 4.4% compounded annual return over the next 10 years.  This compares to my SP500 forecast of, 4.1% in my 10 yr flat market model and 5.2% in the Hussman model. Some bond bubble huh? Of course if interest rates rise much more than 2% this will not be the case. However, I think there is more risk to falling rates than rising ones. Lets not forget the lessons from Japan.

With all that said (you had to know by now this was coming), I still prefer to own dividend paying stocks over bonds. Even in my 10yr flat market model, conservative dividend stocks (say 3% current yield and 5% div growth) will handily outperform bonds, 6%/yr vs 4.4%/yr.

In closing, the bond index may outperform the SP500 over the next 10 years, but dividend stocks will do even better.

Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.