Stocks and bonds: Times are changing

November 15, 2013

For decades, investors have heard an unending chorus of asset allocators singing, “stocks are riskier than bonds” and “the fixed income allocation in your portfolio should be equal to your age.”

Do these investment axioms still hold true?

Throughout the post-war period, the following general market characteristics held true:

  • Stock yields were lower than bond yields,
  • Bonds generally paid more than the inflation rate,
  • Stocks performed well when the economy grew,
  • Should a default situation occur, bondholders were the first to be paid, and
  • Over most measurable time periods, stock returns tended to be more volatile than bond returns.

The table below summarizes the typical risk and return characteristics of stocks and bonds seen in the past.

But portfolio management is more than simply extrapolating past returns into future expectations. As stewards of your capital, our job is to assess how future conditions could impact the returns you expect.

Turning first to Default Risk, one need look no further than Europe to see the risk of a government default is as great today as ever. The historical revenue solution–raising taxes, is verboten–especially in countries where growth is tepid at best. With respect to corporate debt, recent experience suggests that by the time a default occurs, recovery opportunities are extremely limited.

As to Income Yield, the fact that stocks now pay higher dividend yields than those available from government bonds is a situation not seen since the early 1950s. Yields on today’s short-dated government bonds are in many instances less than the level of inflation. Short-term investors are effectively paying governments for the apparent high probability of getting their money back.

Finally, with respect to Gain Opportunities, the traditional high/low paradigm continues. However, should interest rates rise above the level of inflation (the historical norm), the prospect for bonds is not appealing.

In summary, on a look-ahead basis, we see a shift in the traditional risk/reward characteristics for bonds and stocks; more favourable for stocks, less favourable for bonds. For older investors, the implementation of an age equals bonds portfolio allocation could easily backfire as today’s low interest rates ultimately rise to more normal levels in the future. As we saw from May to September this year, when interest rates rise, bond values decline, with long-dated bonds falling the most.

Over the past 30 years, bonds have been the asset class of easy choice. Five years after the financial crisis, the bond table has in our view, turned. The great rotation from bonds to stocks is underway. We continue to see dividend-growing equities as the best way to return to normalcy in the traditional risk/return relationships.