Skip to main content
No. of Recommendations: 0
The correlation between stock prices and bonds prices is never unvarying. But, generally, when stock prices fall, bond prices rise. So, yesterday, I made money again in my four major accounts (roughly $700k face) and probably so in my four minor accounts as well (roughly another $100k face, though I never check them except once a week on the weekend.) But it looks as if 2011 might turn out to be another good year for bond-investors, though a bit short of the 33.6% I made in 2009 across all accounts (after paying my taxes and drawing my living expenses), or the 19.9% I made last year. But, still, something in the range of a 10% to 15% gain for 2011wouldn’t be an unreasonable expectation. Let’s dig into those numbers a bit more closely.

Using Friday’s closing prices as a base, a bond-investor holding a properly-diversified portfolio could expect to have achieved on Monday a one-day gain in the range of 15 to 20 bps and on Tuesday a two-day gain of 10 to 12 bps. (Bonds didn’t rally as strongly yesterday and lowered the running average). By contrast, someone who bought PenFed’s 5% CD could have expected (on a market-day basis) a gain of 2 bps each day. So what are the trade-offs being made?

To hold a portfolio of bonds is to accept a great deal of uncertainty. When stocks rally, you will lose money. When stocks decline, you will make money, on average and over the long haul. Therefore, bonds are a bear market bet on the broad economy. To hold bonds when the economy is roaring is to ask to be killed. But to hold bonds when the economy is languishing is to be granted a reasonable amount of insulation from economic woe, as well as a few bucks with which to put food on the table and to pay the bills. The emotional “cost” of owning bonds, as I said, is a great deal of uncertainty. You don’t know whether you will make money or not. It all depends on the strength and direction of the economy.

To buy CDs, on the other hand, is to buy certainty. You can be absolutely assured that you will lose money on average and over the long haul after paying taxes and subtracting inflation. And the extent to which you can predict what your tax rate will be and what your experienced rate of inflation will be is exactly the extent to which you can predict what your losses will be. By contrast, bonds that aren’t “principal-protected” have a wider range of returns, both to the downside and to the upside. To choose between the two (since PPs and non-PPs are both really bonds) is to make a bet on volatility. In the case of the former (aka, CDs and such) you are betting that volatility won’t work against you. In the case of the latter (betting on non-PPS), you are betting that volatility will work for you.

For sure, a properly diversified portfolio will own a bit of both types of bonds, principal-protected and non-principal-protected, as well as other asset-classes. But, right now, those who over-bet their hand on CDs and such are getting killed, as taxes and inflation reduces their pitiful 2 bps per market day to a negative real-rate of return. And don’t anyone try to say that I didn’t warn you those losses are exactly what would happen.

Charlie
Print the post  

Announcements

What was Your Dumbest Investment?
Share it with us -- and learn from others' stories of flubs.
When Life Gives You Lemons
We all have had hardships and made poor decisions. The important thing is how we respond and grow. Read the story of a Fool who started from nothing, and looks to gain everything.
Contact Us
Contact Customer Service and other Fool departments here.
Work for Fools?
Winner of the Washingtonian great places to work, and Glassdoor #1 Company to Work For 2015! Have access to all of TMF's online and email products for FREE, and be paid for your contributions to TMF! Click the link and start your Fool career.