Beware of long-term bonds — part 2

Feb. 1, 2004
In last month's column, we discussed several economic developments (reminiscent of the late 1960s) that suggest a significant danger of resurgent inflation during 2004 or 2005 — tax cuts, increased military spending in the face of open-ended commitments abroad, the new prescription drug entitlement, weak U.S. dollar, etc.

Marvin Appel, PhD, and Brian Hufford, CPA

In last month's column, we discussed several economic developments (reminiscent of the late 1960s) that suggest a significant danger of resurgent inflation during 2004 or 2005 — tax cuts, increased military spending in the face of open-ended commitments abroad, the new prescription drug entitlement, weak U.S. dollar, etc. Indeed, commodity prices have already risen sharply, although productivity gains have helped keep prices down so far. If inflation does heat up, bond investors will suffer. This month's column presents some defensive strategies you can use.

Intermediate-term bonds have had a better balance between risk and reward than long-term bonds

Long-term bonds are those that mature in more than 10 years. Intermediate-term bonds mature in five to 10 years. Since 1973, intermediate-term Treasuries have had only isolated losing years, while long-term Treasuries posted four consecutive losing years from 1977 to 1980. The risk of long-term Treasury bonds has historically been more than twice that of intermediate-term bonds. (Risk is measured as the amount of price instability in the value of a long-term vs. an intermediate-term bond portfolio.)

The interest income from intermediate-term Treasury notes has been roughly 5/6 that of long-term bonds. Are you better off doubling your risk in search of an extra increment (currently about 0.89% per year) in interest income? Although each of you may be in a different situation, most individual investors should probably start with the presumption that long-term bonds are not worth the risk compared to intermediate-term bonds of similar credit quality.

Moderately cautious bond strategy

You can (with the help of a good broker) assemble a portfolio of individual bonds arranged as a bond ladder with a maximum maturity of no more than 10 years (as we discussed in the very first Practical Investor column back in 2000). With a bond ladder, if interest rates rise, you can reinvest the proceeds from maturing bonds at higher rates. Even though your bonds may temporarily lose value during a period of rising interest rates, with a bond ladder, you will hold every bond to maturity. In so doing, regardless of what happens to interest rates, you know you will eventually get your principal back along with interest income.

For some investors, a mutual fund may be a better way to go. This is usually the case when you have limited amounts to invest at any one time, or if you want to build your bond portfolio by making small incremental investments over time. Since its inception in 1989, the Dodge and Cox Income Fund (ticker DODIX) has been more stable than most other peer mutual funds. Its stability and relatively low expenses have made it a superior performer in terms of reward vs. risk.

Highly defensive bond strategy

Investment grade, short-term bonds (maturing in three years or less) have been very safe because the impact on the value of short-term bonds when interest rates change is minimal. In the world of short-term bond mutual funds, low expenses are far more important than the skill of the portfolio manager. For this reason, Vanguard's short-term bond funds are almost unbeatable, especially in the corporate and tax-exempt categories.

The drawback of short-term bonds and money market funds is that short-term interest rates now lag long-term rates by a historically wide margin. In return for safety against rising interest rates, the short-term bond investor must sacrifice a significant amount of current interest income and may lose purchasing power in the coming year.

If you are fortunate enough to be able to buy individual Treasury securities in a retirement account, we recommend the 1.875% Treasury Inflation-Protected Note due in January 2013 that is currently paying 1.9% per year in interest. Since its principal keeps up with inflation, the flow of interest income increases over the life of the bond, and there is no risk to purchasing power if you hold until maturity.

Recommendations

Most individual bond investors will be well served by holding the Dodge and Cox Income Fund, or the individual inflation-indexed Treasury note due in January 2013. (We recommend inflation-indexed notes only for tax-deferred accounts, and strongly prefer this individual note to available mutual funds in this category.)

Dr. Marvin Appel is CEO of Appel Asset Management. He holds a degree in biochemical sciences from Harvard College and earned his MD in 1991. He is coauthor of Systems and Forecasts. Contact him at (516) 487-7146 or [email protected]. Brian C. Hufford, CPA, CFP, is president of Hufford Investment Advisory Programs, LLC, and Hufford Financial Advisors, companies dedicated solely to helping dentists secure solid financial planning and safe investment strategies. He can be reached at (317) 848-4987.

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