10-year treasuries are at 2%. High-yield bonds dance around historical lows and you are probably wondering if there will be anything left after inflation. Welcome to today’s bond environment where safety of principal is being exchanged for the most minimal of returns.
When speaking to advisors, their concern about today’s fixed-income environment is a recurrent topic of conversation. Just like them you are rightly worried about the returns your clients can expect and whether they will meet their retirement goals.
I wanted to find some sort of solution (or a least some solace) regarding this problem, so I turned to Benjamin Graham. The so-called “Dean of Wall Street” and mentor to Warren Buffett. Below is an old copy of Graham’s Intelligent Investor with my notes scribbled across the pages.
Graham On Bonds
Graham was a fan of U.S. government bonds stating their safety is “unquestioned” this is because of the protection of principal they provided. On taxable vs non-taxable bonds Graham believed this was largely a matter of “arithmetic” in which high earners (and thus likely high tax payers) should gravitate towards non-taxable bonds. On high-yielding junk bonds Graham stated that the ordinary investor was “wiser to keep away” from such issues largely because of the individual risks. Given the development of high yield bond funds where risk is diversified Graham would probably not be so against them.
Graham In 2015
So what would Graham do in 2015 given the current environment? Two items come to mind based on Graham’s works.
- Firstly, there is Graham’s “fundamental guiding rule” – Never hold more than 75% of a client’s portfolio in bonds or stocks. Always balance between 25% on the low end and 75% on the high-end.
- Stocks are usually attractive if the earnings yield is twice the Aa corporate bond yield. Today the earnings yield of the S&P 500 is 5.11%, 80% above the 2.83% Aa corporate bond yield. This means stocks are preferred but they are not a bargain.
So the conclusion is that in this environment Benjamin Graham would have preferred stocks marginally. There are probably still bargains to be had for the “enterprising investor” (active). However, for the passive indexing investor, the market as a whole is not cheap. Unfortunately, Graham doesn’t talk too much about holding cash therefore I took a look at his disciple Warren Buffett’s current cash allocation at Berkshire Hathaway. At the end of 2014, 12% of the company’s assets were in cash or cash equivalents. Worthwhile food for thought.
