Why bonds are a bad deal

You won’t get growth, dividends or protection from inflation—the only thing bonds guarantee are lousy returns

Globe Investor Magazine, Feb. 21, 2008
Illustration by Clayton Hanmer

It’s drilled into our heads from the moment we start investing: To reduce risk and cushion our portfolios when markets keep tumbling, we should always keep a portion of our money in bonds.

Bonds are solid and reliable, like an old friend. Stocks, on the other hand, will shower you with affection one moment, and stab you in the back the next. So, for safety and security, choose bonds.

This advice has been repeated so many times by investment advisers and financial institutions that hardly anyone questions it. And that’s a shame, because, for a lot of investors, particularly those with a long-term horizon, it’s dead wrong.

Why? Because stocks clobber bonds in the long run, even after taking into account corrections and crashes. What’s more, after factoring in taxes and inflation, the return on bonds is close to zero. Does that sound like a safe investment?

One of the most convincing arguments against bonds is laid out in Lowell Miller’s excellent book, The Single Best Investment: Creating Wealth with Dividend Growth. Miller, lead portfolio manager with Miller/Howard Investments in Woodstock, New York, compared the performance of stocks and bonds over 20-year periods from 1926 to the present. The result: During only one period—the one starting in 1929—did bonds outperform stocks, and even then the margin was less than one percentage point.

“In every other 20-year period, stocks outperformed bonds, through recessions and booms, war and peace, famine and pestilence, you name it. And they did so by a mile,” says Miller. “Let me put it bluntly: Bonds are a bad investment.”

Bonds are fine as a savings vehicle. Say you’ve got $10,000, and you need the cash for your child’s university tuition in a few years. There’s nothing wrong with parking the money in a short-term bond and holding it to maturity. The same goes for retirees who need access to their cash. But if you’re trying to build wealth over longer periods, bonds are a lousy choice.

This point is nicely illustrated by Robert Cable in his book Investing on Autopilot. Cable, who is director of financial services at ScotiaMcLeod, used data from Ibbotson Associates showing that U.S. government bonds posted a compound annual return of 5.4% from 1926 through 2004, compared with a return of 10.4% for large-cap stocks.

That 5.4% doesn’t sound bad for a “safe” investment, right? But after deducting inflation, which averaged 3% for the period in question, and subtracting income taxes, which eat up about 40% of the interest, the real, after-tax return on the U.S. bond was a minuscule 0.2%. Using Canada’s slightly higher tax rates, the return was -0.3%. The real, after-tax return on large-cap stocks, by comparison, was 5.3%.

If bonds are such a lousy deal, why do investors, even those decades away from retirement, buy them? One reason is that they may not realize how taxes and inflation eviscerate their returns. A second may be that they can’t tolerate the short-term volatility of stocks. Owning stocks is hard—they soar, they plunge, they go sideways for months or years. That’s why, during turbulent periods such as the credit crunch that’s hammering stocks as this is being written, many investors throw in the towel.

What they fail to realize is that ups and downs, even violent ones, are entirely normal for stocks. Volatility is the price you pay for the superior long-term returns that stocks provide, particularly blue-chip stocks with a track record of rising earnings and dividends.

That’s why investors in it for the long haul should just say no to bonds. Because the only sure thing about bonds is, they’ll prevent you from getting rich.

JOHN HEINZL is an investing reporter and columnist with The Globe and Mail's Report on Business.