Occasionally I am asked why I don’t mention bonds more on the site. In fact I think the only dedicated article I’ve ever published on them was a case study of Vanguard’s Long-Term Treasury Fund. Anyway the reason behind the lack of fixed income articles here is twofold. Firstly, there’s really only so much you can say about owning bonds. After all the long-term capital appreciation of a single issuance is zero if bought at issuance and held to maturity. Secondly, bonds just haven’t looked all that attractive over the past few years.
To better illustrate this let’s take a look at Vanguard’s Long-Term Investment Grade Fund. As the name implies, the fund entirely consists of higher quality long-term debt. As far as I can see the biggest issuers are your household names like Anheuser Busch, Apple and Wells Fargo. It also holds a fairly big chunk of US Government debt. If you were looking for a conservative investment then this would surely be a good option. (Check out the monthly distributions during the financial crisis – they were rock solid while dividend payments were dropping left, right and center). The flip side to that coin is that you would not ordinarily expect total returns to be all that impressive. Indeed underperforming inflation is often the constant worry with fixed income assets such as this.
That said, just check out the fund’s performance over the past few decades. Since its inception way back in the early 1970s it has compounded at an average rate of around 8.20% per annum. The level of real wealth creation – i.e. after stripping out the effects of inflation – comes to something like 4.5% per annum. To put those numbers into context you are looking at every dollar invested in 1973 being worth $7.25 now even after you have accounted for the erosion in purchasing power arising from over forty years worth inflation. For a fund consisting entirely of investment grade bonds I would say that is a very impressive figure.
The flip side to that coin is the future outlook doesn’t look nearly as good. As it stands the fund currently yields 4.1% according to the Vanguard website. In other words if you were looking at that 8.2% figure as a guide to total returns then you are going to have to conjure up another 4% per year to go on top of the current distribution yield. That seems to me to be rather unlikely to occur.
A better way to think about what be to line up the fund’s valuation next to a basket of equities. The most well known blue chip index like the S&P 500 currently trades at a price-to-earnings ratio of around twenty. Turning that number on its head gives us an earnings yield of about 5%. With a bit of luck it is now clear why I said that bonds don’t currently look that attractive. If an investor can get a roughly 5% “yield” from blue chip equities, plus the reasonable expectation of future earnings growth, then a blue chip bond fund yielding just over 4% doesn’t look particularly noteworthy.