Mon, 23 Sep 2013
Income investors concerned about heavy government-bond concentration in the Barclays Aggregate Bond Index should consider dividend payers and the bonds of countries with low debt/GDP ratios, says the Princeton professor.
Christine Benz: Professor, you touched on government bonds, and I'd like to look at the Barclays Aggregate Bond Index. Some people, even people who are extreme index enthusiasts, look at that index which is roughly two thirds weighted toward government bonds. Do you view that as an adequate index? Should people just buy that market and call it a day, or do you think that that index could use some adjustments?
Burton Malkiel: I'm not sure that the index could use the adjustment, but what I have recommended--and this gets into another area, but it's, I think, very important today--I don't think it's the index that's the problem. I think the problem is that we live in an era of financial repression, where governments in developed countries are having enormous deficit problems. They have very high debt/gross domestic product ratios. They have embarked on policies to make those high debts able to be carried with some degree of ease. They've done it by suppressing interest rates, and that's suppressing interest rates to rates below the rate of inflation. Certainly on any kind of short- to intermediate-term government bond you're talking about returns that are below the rate of inflation.
So what do you do? Incidentally, just thinking of that, we've lived through this before. We did this at the end of World War II. It was the last time rates were about the same place where they are today. Government rates were about the same as they are today. They were pegged until the early 1950s, and then they were allowed to rise only gradually. Bonds were a horrible investment through the whole period of the ‘50s and ‘60s and ‘70s, up until 1980.
If you want to me to say that I'm worried that holding an exchange-traded fund, such as Vanguard Total Bond Market ETF, may not be the greatest thing in the world, yes, I agree with that. In terms of my association with Rebalance IRA and Wealthfront, for at least part of what might have been the traditional bond portfolio, we've done two things. One, we've included more foreign bonds, including bonds in countries that have the lower debt/GDP ratios, lower government deficits, and higher yields. We are not simply using the U.S. for our bond portfolio.
The second thing we have done in this financial-repression environment is an equity substitution for some part of the bond portfolio. And the equity substitution is with high-quality dividend-growth stocks that have much more stability than stocks in general but are likely, I think, to have a much better risk/reward ratio. The example I like to give is, if you take a 10-year AT&T bond, you're looking at yields of 3% or 4%. If you look at AT&T's stock, you are looking at a dividend yield of 5%, and that dividend has grown over time at 5% a year.
Now I'm not going to tell you that the dividends will continue to grow at 5%, but I think with growth in the economy, there's a reasonable chance that the dividend will continue to grow, maybe at a lower rate, but will continue to grow over time. I can't believe that AT&T stock won't give you a higher rate of return than AT&T bonds. The bonds are supposedly far more stable, but remember back to our other experience of the bond market from the ‘50s to 1980, there were periods where bonds were even more volatile than stocks. I think there is a real danger in saying, "I'm going to have bonds, and I'll just do Vanguard Total Bond Market ETF," for the reasons that I've just given you.
I'm not going to tell you that I would change the index. I think that's not the answer, but I think you want to be fairly intelligent about how you use it.
Benz: Right. Now, there are lot of investors who have gone completely in the other direction and have said, "Forget bonds, I am just going to own dividend-paying stocks." I am guessing you don't think that that's an entirely wise strategy either.
Malkiel: No, I wouldn't go 100% that way, but I certainly would move in that direction.
Benz: Professor, well, thank you so much. You've been more than generous with your time, and it's been a real treat to get to hear your insights into these important topics.
Malkiel: Good. Thanks a lot.