Why a Government Bond Investment Stinks

by Neal Frankle, CFP ®

I get lots of questions about the best way to invest money – especially when the market is turbulent like now. When I do get those calls, government bonds are usually something people ask about.  I always try to answer by giving a little history lesson.  Let’s me give you some perspective to explain why I typically do not like government bonds.

History Class

On May 15, 1984, the Treasury department auctioned $5 billion of 30-year bonds (callable after 25 years) with a fixed coupon rate of 13.25%. This means you could have purchased government bonds and been guaranteed a double-digit return for a minimum of 25 years.

Today, that looks absolutely incredible.

Why were government bonds paying so much in May 1984? Well, try to remember the splendor of the 1970s. We had the energy crisis, double-digit inflation, stagflation and recessions. It wasn’t a lot of fun. That, coupled with the failure of Continental Illinois National Bank and Trust during the same month, made people hesitant to lock up their money at a fixed rate. To get money out of the mattress, the government had to offer a very high interest rate.  Even at that high rate, people were skeptical believe it or not.

Today, we face almost the exact opposite situation with the 30-year bond. The yield is below 3.5% (5-22-14) yet some investors are eager to buy. Are investors who buy 30-year bonds at today’s low yields making the same mistake as investors who were too scared to buy 30-year bonds at a 13.25% 30 years ago? In other words, are they doing the wrong thing at the wrong time?government bonds

In my experience, it’s important to notice how fear plays a role in the value of investments. Back in 1984, people were fearful of locking their money up at a historically high interest rate with the memory of the previous decade’s bad news still fresh in their minds. Today, the fear of uncertainty has driven down the yields of 30-year bonds to near historic lows as some investors seek out the safest investments.

All this leads us to the stock market. I suggested back in 2009 that it might be possible that the steep market declines of 2008 might be a replay of the May 1984 bond market situation. Specifically, fear and legitimate economic woes caused the stock market to drop dramatically.  I suggested that we might look back and say, “Oh my gosh, it would have been a brilliant investment to go long in the stock market back in 2009”?  Of course I didn’t know that in fact would be the case.  But I did suggest that nobody knows what the future holds – nobody.

Bonds are good investments for some people sometimes.  But bonds are usually not well suited for long-term investors – even those who want current income.   They provide diversification and a measure of short-term security but not return.   My suggestion is not to buy bonds now just because the market has become a bit more rocky.  There are far better ways to invest.

Do you disagree?  Are you a fan of bonds?  Why?

 

 

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