Should you sell your bonds and move your funds into stocks? This is the age-old question (sometimes reversed) when it comes to investing. Companies issue stocks and bonds to raise cash for their operations (or to pay shareholders), yet they are so fundamentally different that investors place them in separate asset class categories.
Investors basically like stocks when economic growth suggests companies will increase their earnings in the future and they can benefit from higher dividends down the road.
Conversely, investors like bonds when an economy is heading into recession. By buying quality bonds -- that is, bonds issued by companies with investment grade-ratings -- investors hope to lock in yields that are likely to drop as the economy contracts and interest rates correspondingly decline.
Whether you should sell your bonds right now depends on how you see the overall economy playing out over the next couple years, as well as on your expectations for interest rates.
Are we heading into a boom?
The latest economic data gives credence to my belief that the U.S. economy is heading into a boom. U.S. gross domestic product rose 4% on an annual basis in the second quarter, unemployment can still improve, interest rates and inflation are low, and home construction is going strong.
Stocks already have done well for investors for the better part of the last five years. While a consolidation can happen at any moment, stocks could have even more potential in the coming years as earnings growth accelerates and interest rates normalize.
The influence of interest rate movements
The interest rate cycle has a profound influence on the price and yields of bonds.
As interest rates increase, bond prices head south. Why?
If interest rates rise investors reduce the price of an existing bond because new bond issues will now have to offer higher yields (or coupons) in order to reflect the higher interest rates prevailing in the economy. In other words: Higher interest rates cause the price of an "old bond" to fall because investors now have higher-yield choices along the bond spectrum, making the old bond less attractive.
The return from bond investments can come from changing prices (that isn't the case if you hold your bonds until maturity, as you will recoup your principal) and from coupon income. In an environment of increasing interest rates, bonds are not preferred investments.
Since interest rates are still near zero and may stay low for a little longer, they really can only head north and, in the process, will exert a lot of pressure on bond investments.
High risk or low risk
If stocks are generally too risky for you, then bonds are probably the right way to go. But they are not risk-free investments. Companies can default on their debt obligations, which is more of an issue in contracting markets when the economy does poorly.
If you select a bond investment due to your risk aversion, make sure the company issuing the bonds has an investment-grade rating, which indicates a comparably low default risk.
Long-term performance record favors stocks, not bonds
Whether you own a few bonds or a portfolio packed with them, know this important fact: Over very long performance measurement periods, stocks have outperformed other asset classes such as bonds or T-Bills.
Consider the chart below, which compares the returns of stocks, bonds, and T-Bills from 1926-2013. It becomes clear that stocks are hard to beat.
Though bonds can surely outperform in certain years or markets, stocks are the preferred choice for long-term investors. The performance record suggests that equity investments should continue to deliver good results, on average, in the coming years.