chapter seven

BONDS

Are They Only for Wimps?

U.S. History Has Favored the Bold

Bonds are for wimps! So declared Harvard Professor Greg Mankiw in 1993 when I was a Ph.D. student in his macroeconomics class. Professor Mankiw is not only a world-class researcher, but also a great communicator. I found him to be an excellent teacher, and his ability to make economics interesting has allowed him to write several best-selling textbooks.

When Professor Mankiw said, Bonds are for wimps, I dont think he was making an investment recommendation. Rather he was being a great teacher by using colorful phrasing instead of using the technical term the equity premium puzzle. 1

The academic research on the equity premium puzzle examines the money that has been made in U.S. stocks and U.S bonds. What was the conclusion of this research as of 1993? Bond investing had provided safe, but unspectacular, returns. Over the history of the United States, those investors willing to take a flyer on risky stocks would have made much more money than bond investors, even when adjusting for the more volatile nature of stocks. With the benefit of hindsight, therefore, only the

extremely timid (a.k.a. the wimps) ought to have chosen U.S. bonds over U.S. stocks.2

Warning: Past performance is no guarantee of future returns. Every mutual fund has such a disclaimer. All of the research summarized by Professor Mankiw examined the past. In 1993, it was true that throughout the past, U.S. bonds had been worse investments than U.S. stocks.

Obviously, investors ought to care about the future not the past. Accordingly, this chapter analyzes the outlook for bonds, not just past performance.

Before starting on our bond journey, a few preliminaries are required. First, were going to look at only U.S. government bonds. The bond universe encompasses many other bonds including junk bonds, municipal bonds, and many more. Why do we only cover government bonds? Because of the story of the goat.

Two men go to a car junkyard looking for spare parts for a classic vehicle. The junkyard is large, so the owner suggests that the men look around to see if they can find a junked car with the needed parts. Interestingly, the owner warns the men to look out for his pet goat.

During their walk through the junkyard, the men pass a hole in the ground. One of them kicks a pebble into the hole and both are surprised that they do not hear the pebble hit bottom.

As might be predicted, the men forget their spare parts mission and begin throwing larger and larger items into the apparently bottomless hole. After some minutes, and still unable to hear anything hit bottom, they heave a transmission into the hole. Soon afterwards, a goat runs up to the side of the hole, pauses, and then jumps into the hole. Shaken by the goats apparent suicide, the men return to the junkyard owner.

Did you find your parts? the owner inquires. Without mentioning the items they had thrown in the hole, the men tell the owner about the goat that jumped to his death. The owner says, Thats funny, but it couldnt have been my goat, as mine was securely tethered to a transmission.

In the bond world, U.S. government bonds are like the car transmission while all other bonds are the goat. If U.S. government bonds sink in

value, they will drag all other bonds down with them. There might be some delay while the other bonds teeter on the edge, and some goats may have longer ropes than others. Nevertheless, if U.S. government bonds decline in value, so will all other U.S. bonds.

What about the possibility that bond prices will soar? As we will see, that is not possible. In the current environment, bond prices can either fall or perhaps rise modestly. The first message in this chapter is: U.S. government bonds will measure the speed and length of any decline in the bond market. Thus, we keep our eye fixed on these bonds.

The second message is: Bond prices move in the opposite direction of interest rates. In other words, rising interest rates are bad for bond owners.

Why are rising interest rates bad for bondholders? This can be confusing, and the reason for the confusion is as follows. Is it better to earn 4% or 8% on a bond? The answer is obvious; the 8% bond is better. So rising interest rates might seem good for bondholders. The answer is exactly the opposite: Rising interest rates are bad for bond owners. Falling interest rates are good for bond owners.

The potential confusion is resolved by clearly separating todays bond prices from future returns on bonds. My friend Chris (the MIT rocket scientist we met earlier) and I recently had a similar revelation in a nonfi-nancial situation. Chris is a great athlete and better than I at every sporting activity we have played, at least until recently. A frigid Boston winter forced us indoors, and we decided to begin playing racquetball. Because I had played a lot of racquetball previously, I soundly beat Chris during our first match.

After the drubbing, Chris was a bit morose, especially given his history of outrunning and outplaying me in a variety of sports. I said, Losing badly was the best possible outcome for you. When he asked me to explain, I said that he had nowhere to go but up. As we continued to play each other in a series of matches, Chris performed steadily better. Our first match was a short-term defeat for Chris, but set him up for months of steady progress. The worse he did in the initial match, the better his prospects for improvement.

A similar situation exists for bonds, especially government bonds. The