When to Buy Bonds Over Stocks
When should you invest in bonds rather than stocks?
Stocks and bonds are alternates.
This tenant used to be sacrosanct in the American investing lexicon. Sadly, this once well understood phrase appears to have faded into the miasma of modern financial education. A once obvious precept of investing is now unclear in the minds of all who dare invest or save.
Stocks offer an inherent risk premium not found in bonds. Also referred to as equity, ownership of a business, stocks are the first class of investors to be wiped out in the event of a liquidation of a business. But with this risk, comes reward. As a perpetual coupon on the future earnings of a business they can last into eternity. And, as the business grows, so can the rewards of cash and value appreciation to owners.
Bonds on the other hand, are set coupons paid by issuers to borrowers in predefined amounts. Their return is fixed and can be easily calculated. If the business grows from the use of their issuance they typically provide no additional benefit for the purchasers outside of the fixed coupon amount. Except, when a business goes belly up they traditionally have priority rights to the remaining assets in front of equity holders.
Contrasting maturity and return profiles of stocks and bonds shows that over a long period of time, the implied return from equities exceeds that of bonds.
Let’s say that stocks historically return 11% (S&P 500) and bonds are yielding around 6%, the alternative to investors is a choice of risk of ~5% and surety of payments. As interest rates rise, investors re-value the risk they are willing to pay for equities. Because of the nature of the protections built into bonds, the higher the interest rate paid on a bond the better alternate it becomes to a stock. Thus, alternates.
What is meant by referring to stocks and bonds as alternates is the difference in opportunity cost for investors as a whole. You can invest in either stocks or bonds. Most rational people make decisions based on opportunity costs.
In economic terms, when bond yields rise, the demand for bonds increases and the demand for stocks decrease. Historically bonds offer more secure returns even though they have a lower implied yield (expect for when they don’t).
In the 1980s the 30 Year Treasury Rate’s yield, the risk-free rate, was as high as 15.08%, and well north of 12% for the better part of half a decade.
Any investors who purchased bonds north of 11.5% would have materially outperformed nearly all professional investors as a class for three decades.
The answer for when to buy bonds over stocks is simply when the rate of return is greater than the expected return for equities.