Even At These Rates, Bonds Are No Substitute For Stocks

Even At These Rates, Bonds Are No Substitute For Stocks
Paul Allison, CFA

4 months ago4 mins

  • Unless you’re able to reinvest all your bond coupons at 5% or higher, an investment in a stock that compounds at 5% will give you a much better return.

  • That means bonds aren’t really such a great alternative to stocks, at least not as far as returns are concerned.

  • There are certainly benefits to holding a diversified portfolio of bonds and stocks, but for long-term investors, it still makes more sense to allocate the biggest part of your portfolio to stocks.

Unless you’re able to reinvest all your bond coupons at 5% or higher, an investment in a stock that compounds at 5% will give you a much better return.

That means bonds aren’t really such a great alternative to stocks, at least not as far as returns are concerned.

There are certainly benefits to holding a diversified portfolio of bonds and stocks, but for long-term investors, it still makes more sense to allocate the biggest part of your portfolio to stocks.

With government bond yields now offering returns that are substantially better than they’ve been in ages, plenty of people are saying that bonds are now a reasonable alternative to stocks. And, I get what they’re saying: the very long-term return for stocks is around 7%, so with the current 5% yields, bonds come pretty close, right? Well, not exactly.

Now, I won’t deny that holding both stocks and bonds as part of a diversified portfolio is a savvy move. Bonds can be a great diversifying asset, after all. But, if we’re talking about returns, nothing beats stocks for the long-term investor.

Look, here’s a little math.

If you invest $1,000 into ten-year US government bonds with a 5% yield, you’ll be paid $50 a year for ten years and you’ll get your $1,000 back at the end – assuming the US government is true to its word. For bond enthusiasts, that assumes a 5% coupon on a bond that you bought at par value. For bond non-enthusiasts, let’s just run with the fact that 5% of $1,000 is $50. What this all means is that you’ll be getting ten yearly payments of $50 and your $1,000 back. That’d turn your $1,000 into $1,500, then, for a 50% return.

Now, let’s say you’ve found a company that you’re pretty confident will grow its profit at 5% a year for the next ten years. You believe it’s a solid firm with sound long-term prospects, and you’re prepared to pay a 20-times price-to-earnings (P/E) ratio because you’re confident that you’ll be able to sell the stock in ten years for the same 20 times earnings. Incidentally, 20 times is roughly the average multiple for the S&P 500. Let’s say this firm is about to close its books on the year and produce $50 per share of profit. That means you pay $1,000 per share for the stock (20 P/E x $50 earnings per share).

Here’s where the magic of compounding comes in. If every year your company grows profit by 5%, that $50 would be around $81 after ten years. And that means you could then offload your shares at 20 times for a price of $1,628. That’d be a 63% return, a fair bit better than the bond’s 50%.

“Wait just a minute!” you’re thinking.

I know: there’s a massive flaw in this comparison. You’re not going to just stick your yearly $50 coupons under the mattress. You’ll probably reinvest them into more bonds. And if you do reinvest those $50 payments into new bonds at 5% every year, then your return would be identical to that hypothetical stock return. You’re right.

But remember: 5% profit growth is not a massive ask on your company – in fact, it’s a fair bit lower than what you should expect from stocks over time. Conversely, that 5% bond yield is an outlier: that’s the highest the yield has been in the past 10 years, as you can see in this handy chart.

The US ten-year government bond yield, since 2013. Source: Trading Economics.
The US ten-year government bond yield, since 2013. Source: Trading Economics.

Bond yields could, of course, stay at this level (or even rise) over the next ten years. And at that point, my whole argument would embarrassingly fall over. (Although I figure I know a fair number of stocks that’ll grow profit faster than 5% over the next decade).

But investing is a game of odds, and if you ask me, I’d say the odds are better than 50/50 that yields will slide lower in the next ten years. Plenty of people would disagree with me on that, but I feel pretty optimistic that AI is going to unleash a massive wave of inflation-killing productivity on the world.

OK, just a few final points.

Look, the longer you hold onto stocks and the more you let compounding do its thing, the stronger my argument becomes (and, the stronger your returns will be, too). What’s more, when you buy stocks, you’re giving yourself a shot at things actually turning out better than you initially expected. On the other hand, with your bond investment, there’s absolutely no chance of upside beyond the yield on the bond you buy. So, by all means, add some bonds to your portfolio to diversify your risk, but if you’ve got a long-term time horizon, consider keeping the vast majority of your portfolio in good ole stocks.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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