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Notes From the Fieldby Martin Weil

February 14, 2012

Is the decade-plus run in fixed income reaching its end?

In 1999, soon after I started this business, if you had said that bonds would outperform stocks over the coming decade, that my Conservative and Balanced portfolios, with their heavier allocations to fixed income, would outperform my more equity-focused Growth portfolios, I would have not considered that to be a highly unlikely outcome. Yet that is exactly what occurred. And today, after more than a decade of outperformance by fixed income, and unnerving turmoil in the equity markets, bonds are now “hot” (as hot as bonds can be), and equity investments increasingly out of favor. Yet the critical question for investors seeking to build, or preserve, their savings in the coming years is whether this state of affairs will continue. As a recent article from Tradewinds Global Management put it:

In a way, today’s bond market feels like the 1999 stock market, when technology companies were all the rage… Three decades ago people hated bonds. Yields of 15 percent for 30 years were considered certificates of confiscation. Investors thought governments couldn’t be trusted, $150 billion deficits were too high and 4 or 5 percent money supply growth was too much. Therefore, they didn’t want to lock up money at 15 percent.

Obviously, that was the perfect time to lock up money. Now 30-year rates are less than 3 percent, with the 10-year U.S. Treasury yielding less than 2 percent. And oddly enough – just like the tech stocks in 1999 – people are rushing to buy them …

The risk is exceptionally high. If things go well for bond holders, the potential reward is 3 percent per year for 30 years. If things don’t go well and rates return to 15 percent, bond holders would lose more than three-quarters of their money. This is return-free risk.

This is a challenge for those who must meet retirement needs, or meet the needs of endowments, foundations and pension plans. Where can one go? Various places, including alternatives and real estate – and of course the stock market.

A colleague wrote last month, “while I am not overly attracted by what I consider a stock market that is fully valued, I held my nose and bought.” No less than Warren Buffett has advised that stocks are poised to return to outperforming bonds in the years ahead. Not without volatility of course, and investors should carefully calibrate their own needs and risk tolerances. But given the near-inevitability of mean reversion (or “anything that can’t go on forever, won’t”), the probability of bonds continuing to outperform stocks in the coming decade is small indeed.

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