Lack, Bonds Are Not Forever

As you might guess from its title, Bonds Are Not Forever: The Crisis Facing Fixed Income Investors (Wiley, 2013) is an admonition about investing in bonds under current conditions. Simon A. Lack, who dealt with the fixed income market for many years at J.P. Morgan, is not a bond basher in general. Indeed, bonds have been a good place to be. “Bonds outperformed stocks during the first decade of the millennium, and the buyer of a 30-Year Treasury bond at the peak in yields in 1981 also outperformed equities during the subsequent 30 years.” (p. 189) Now, however, it’s time for bondholders to pull up stakes and move on.

Even though many others have sounded the alarm on bonds, Lack offers a historical framework, anecdotes (at times amusing and at other times scary), and compelling analysis in support of his position.

Here I’ll focus on two related reasons that bondholders should bail. First, “nominal yields that are close to and below inflation ensure that the investor will get back less purchasing power than he gave up when he bought the bonds. Figure in taxes and it’s worse. Moreover, real rates on government and investment-grade credit are unlikely to provide the 2 to 3 percent cushion above inflation that ought to be the minimum requirement of lenders.” (p. 190) Second, “even earning a return on bonds that beats inflation after taxes doesn’t ensure a secure future for those planning their retirement.” (p. 191)

Most people assume that beating inflation means beating the CPI. But there is a disconnect between the CPI and consumers’ daily purchasing experience. As Lack writes, the folks at the BLS “don’t measure what we care about because it’s too hard; they measure what they can, and we mistakenly think they’re counting what counts to us.” (p. 185) For instance, we think they are measuring the cost of owning a home, aka the bottomless pit, but in fact they’re measuring what the home would rent for. Moreover, they construct their index by asking homeowners how much they think their home would rent for, as if homeowners were the ultimate real estate experts. The BLS disregards such things as mortgage rates, property taxes, insurance, and maintenance and measures only utility bills. (Even here, if you heat with natural gas you win; with heating oil, you lose.)

And then there’s the problem of the “hedonic quality adjustment” in the CPI. The BLS doesn’t measure the cost of a constant standard of living but the cost of constant utility. For instance, “if your standard of living includes being able to afford the latest iPad, and the latest iPad costs what the older version did, you don’t feel as if your standard of living has improved. The BLS would record an increase in your utility (because you bought more iPad for $500 than used to be possible), but you’ve simply bought the latest iPad.” (p. 179)

In brief, people who simply keep up with the CPI “will experience a steadily declining standard of living. You’ll have last year’s utility when you really want this year’s to maintain your relative standard of living.” (p. 185)

Where should a bondholder go? Equities are the obvious alternative; holding some cash adds stability to a long-only portfolio. Lack provides two tables to guide the investor, one that shows the percentage of stocks needed to earn an equivalent treasury bond return and another that compares drawdowns in cash and stocks versus bonds.

Even if you’ve heard this song before, Lack offers interesting embellishments. In my opinion the book is worth reading just for the anecdotes. Did you know, for instance, that until 1986 brokers from the British brokerage firm Mullins were required to wear top hat and tails every day on the trading floor? Of course, there’s a lot more to Bonds Are Not Forever than curiosities. It is an insider’s view of what outsiders should know and, as such, should be required reading for every retail bond investor.