Taking Stock of Bonds:
A Meditation

Everybody knows the stock market's been red-hot. But 1999 was bummer for bonds. "The bond market is suffering its second-worst year on record," wrote Greg Zuckerman in the September 13 Wall Street Journal, "and small investors are getting bruised as much as pros."

We know we're supposed to buy stocks and mutual funds when there have been cataclysmic price drops. But when are we supposed to buy bonds and bond funds? A professor of finance, Paul Koch, talks about how to think about this issue.

Let me speak directly to your question, then to some larger issues. The flavor of your question suggests a desire to "time" purchases and sales of investments in stocks or bonds in order to benefit from short term expected movements in stock markets or interest rates.

I am not enamored with anyone's ability to consistently and successfully predict short-term stock market or interest rate movements. Therefore, I would not advocate actively buying or selling stocks and bonds in an effort to time short term market moves. I believe that, over time, this strategy is likely to perform poorly. Of course, this belief does not always keep me from trying to do just that myself. In such an effort, I would only counsel individuals to do their homework and strongly consider the fundamental underlying economic value of what they are buying in relation to how much they are paying.

In a more general sense, stock markets, like bond markets, generally benefit from economic developments that reduce interest rates; the opposite generally holds when interest rates rise. In this way stocks and bonds behave similarly over the long run.

Equities - stocks - are fundamentally different from debt instruments - bonds - in that holders of equities participate in the profits (or losses) of the underlying businesses after debt-holders have been paid off. Debt-holders, on the other hand, have a prior fixed claim on the earnings and assets of the firm. They do not participate fully in the potential profits of the firm, but only hope to receive their investment back with interest if the firm does well.

Both equity and bond holders expect to gain over the long term when economic conditions favor the performance of companies underlying the claims. However, equity holders accept more risk over the short term, since their claims are hurt more when the firm performs poorly. As a result, equity returns are generally more volatile - are subject to higher highs and lower lows - than returns on bonds over the short term. This means that, in the short run, equity holders should expect to experience periods when their holdings perform much worse than bonds.

However, over longer periods of time, equities have historically overwhelmingly outperformed bonds. This enhanced performance of equities comes from the nature of the equity claim, which entitles the holder to participate in the good fortunes of the company. In return for the extra risk over short periods of time, equities are expected to pay a higher return over time.

In this sense, one might argue that it is actually more risky to buy bonds than stocks, if your investment horizon is a longer time frame, say 20 or 30 years (or even 10 years). Over such long time horizons, equities have, in the past, almost always outperformed debt. Of course, it is not necessary that this historical behavior will repeat itself in the future. However, the nature of the two claims strongly favors equity over debt over long periods, if we expect a growing worldwide economy, because equity holders will participate in this future growth while debtholders only hope to receive their investment back with interest.

Paul Koch, professor of finance
School of Business

Koch team-teaches "Applied Portfolio Management" with adjunct professor Kent McCarthy