Thanks to the crisis in Europe and a blossoming fiscal deficit closer to home, the question of how much debt is too much has taken center stage in many economic circles. As nations struggle under the weight of their financial load, concerns about how the global debt will affect returns on investments is foremost in many investors' minds.
The good and the bad
At the CFA Institute's recent annual conference, several luminaries discussed the indebted state of the global economy and how that may affect desired asset allocation for individual investors. Vanguard founder Jack Bogle reiterated his age-based approach to asset allocation, where an investor's allocation to fixed income should be roughly equal to his or her age. On the other side of the fence, Chris Davis, who leads the Davis Funds, stated that bonds were "the most dangerous asset in the world," thanks to all the money that has been stuffed into bonds in recent years after the easy money had already been made.
So who's right? Should investors approaching retirement have roughly 60% of their assets in bonds, or should they run screaming for stocks because bonds are a bad buy right now? Well, I certainly agree that the best days for bonds are behind them. Historically low interest rates have nowhere to go but up, and that spells trouble for the bond market. But for investors who need to protect their capital, there simply is no reliable substitute for fixed-income instruments. That means bonds will continue to play an important role in almost every investor's portfolio for years.
The middle ground
As the resident mutual fund advisor for the Fool's Rule Your Retirement service, I generally recommend that investors with more than 10 years to retirement only allocate around 10% to bonds, those within 10 years aim for roughly 35%, and those folks in retirement shoot for about 55%. That leads to a more stock-heavy portfolio than Bogle's approach, but it's certainly more optimistic about bond holdings than Davis' doomsday outlook. While more conservative investors have more of a need for bonds, they should still have a meaningful allocation to stocks to allow their portfolio to fund a retirement that could last 30 or more years.
All investors need broad fixed-income exposure -- the cheaper, the better. If low-cost, wide-coverage exchange-traded funds like Vanguard Total Bond Market ETF (NYSE: BND) or iShares Barclays Aggregate Bond Index (NYSE: AGG) aren't a part of your portfolio, you might want to consider adding them. In addition, folks who are nearing retirement should have a good serving of inflation-protected bonds to help preserve their purchasing power. One of the best in this space is Vanguard Inflation-Protected Securities (VIPSX).
The power of the dividend
But Davis hits on an important fact: Bonds as an asset class are simply not that attractive right now. And while investors who are in retirement should have a majority of their assets in bonds, they need to look at these instruments as tools to protect capital and dampen volatility, not as long-term wealth-builders. I also concur that bondholders may be in for a rude surprise if they think bonds will outperform stocks again over the next decade. At the CFA Institute conference, Davis highlighted that stocks make more sense now, especially given current dividend yields. I'm in agreement that dividend-yielding names are an excellent place for investors to be putting new money to work.
For example, Coca-Cola (NYSE: KO) and PepsiCo (NYSE: PEP) are both industry leaders with dividend yields in excess of 3%, and with P/E ratios of roughly 17 and 16, respectively, both trade below the S&P 500's current earnings multiples. Similarly, Kraft (NYSE: KFT) and Procter & Gamble (NYSE: PG) not only have healthy dividend yields, but have also recently increased their dividends, and are growing revenues even in a challenging economic environment. If you're looking for names that will be able to thrive and boost your portfolio in a debt-laden world, these are the stocks that are in the best position to do just that.
One thing is for certain: Global growth is likely to be held down quite a bit in the coming years as heavy sovereign debt loads weigh on results. Bonds aren't likely to be the savior that many investors think they will be, so be sure to moderate your expectations here while continuing to adhere to your long-term asset allocation.
