Princeton University professor emeritus Burton Malkiel and the author of the popular book A Random Walk Down Wall Street wrote in the Wall Street Journal The Bond Buyer’s Dilemma. Professor Malkiel suggested some reasonable alternatives to long-term U.S. Treasuries.
"The first is to look for bonds with moderate credit risk where the spreads over U.S. Treasury yields are generous."
Professor Malkiel gave muni bonds as an example for this. I agree.
Yes muni bonds have more risk but the spreads are generous. Pension funds and foreign governments don’t get the tax advantage from investing in muni bonds; individual investors do. When we as individual investors buy muni bonds, we get a break because we are not competing with pension funds and foreign governments.
For this reason, I hold muni bonds in my taxable account and value stocks in my tax deferred accounts. See previous post Dividend Tax Going Up, Moving to Munis.
Professor Malkiel then suggested close-end funds that invest in muni bonds with a leverage. I don’t think we need to go that far. Leverage increases risk. High management fees in close-end funds also take away some returns. Plain-vanilla muni bond funds will do.
Professor Malkiel also suggested
"Another class of bonds that is attractive today is foreign bonds in countries that have much better fiscal balances than we have in the U.S."
He gave Australia as an example.
"High-quality Australian private bonds are available at yields of 8%."
I’m not sure what high-quality Australian private bonds he’s talking about. Note the word "private." It sounds like corporate bonds, not Australian government bonds. I don’t know how private bonds have anything to do with a country’s fiscal balances. Bloomberg shows yield on 10-year Australian government bonds is 3.7%, higher than the 1.9% yield on 10-year U.S. Treasury, but nowhere close to the 8% number Professor Malkiel mentioned.
I don’t have a good explanation for why Australian bonds would yield that high. I assume the market knows something I don’t. Maybe it’s forecasting that the value of the Australian dollar will fall.
I’m taking a pass on this one because I just don’t know enough about foreign bonds that yield higher. Yield on a more diversified foreign bond ETF, for instance SPDR Barclays Capital International Treasury Bond ETF (ticker BWX), is only 2.5% with a duration of 7 years. It’s not that much higher than the yield in the U.S.
Finally, Professor Malkiel suggested
"Another strategy would be to substitute a portfolio of blue-chip stocks with generous dividends for an equivalent high-quality U.S. bond portfolio."
Here, I both agree and disagree with the suggestion. With a low bond yield, I think a reasonable case can be made that stocks will have a higher return than bonds. Therefore increasing the allocation to stocks will increase a portfolio’s return.
During late summer early fall when stocks went down and bonds went up, I rebalanced from bonds to stocks. It worked. Stocks rebounded, not completely, but enough to beat the return in bonds.
However, will "blue-chip stocks with generous dividends" be better than other stocks? It’s not that clear. Dividends give you the comfort you are getting something, but it’s the total return that counts. I would focus on total return, not just dividends.
In his article How to invest in a low-interest-rate world, investment advisor Larry Swedroe agreed that muni bonds are a better bet but he disagreed with Professor Malkiel on foreign bonds and high-dividend stocks.
Investment advisor Allan Roth also disagreed with Professor Malkiel. His solution is FDIC-insured CDs with low early-withdrawal penalties.
I’m with Allan Roth on this one. If you are holding bonds in a tax deferred account, you are better off with FDIC-insured CDs. The good CDs have a higher yield than Treasuries. They have a similar yield to investment grade corporate bonds but at a lower risk. They also have a lower interest rate risk than both Treasuries and corporate bonds. What’s not to like?
Once again, we as individual investors are better off with CDs because we don’t have to compete with pension funds and foreign governments.
The same is true for I-Bonds: no competition from pension funds and foreign governments. Fixed rate is stuck at zero when short- and intermediate-term TIPS yields go negative.
In summary, here are my solutions to the bond buyer’s dilemma:
- FDIC-insured CDs in tax-deferred accounts (PenFed, Alliant CU, Ally)
- I-Bonds in taxable accounts (TreasuryDirect, $10,000 per person, including buying with tax refunds)
- Muni bond fund in taxable accounts (Vanguard)
- Buy more stocks when prices are low