Bond With Your Bonds

As an investment advisor it seems that we have a daily conversation with an investor who is running for the exit with whatever is getting trashed in the media. Last April, it was European equities. This month it has been bonds. The prognosticators have spoken, and apparently the news has finally leaked out to the masses: Inflation is either here or just around the corner, and with it the great and terrible day of reckoning for bonds. Yes, a dot-com-sized bubble has inflated the bond market before our very eyes, leaving only the most foolish among us still holding on to our bonds. When the bond market finally craters, it will be the stubborn few taking the punishment-pigs, as they say, deserving slaughter.

The consensus for fleeing bonds has become more powerful with each passing week. The first notable warning shot came from Warren Buffett at his annual Berkshire Hathaway meeting when he predicted the future demise of the bond market. Soon after, the Vanguard Group announced worries about bond instability. Journalists, economists, and wealth managers have joined in chorus proclaiming disaster in the bond market. With such a dire consensus, why would any investor still buy bonds?

One idea investors should understand is what we call the Third Newtonian Law of Economic Motion: For every economist, there is an equal and opposite economist. You don’t have to look far to find great minds lining up on the side of a long deflation wave fueled by a mind-boggling backlog of massive debt. Take Jan Hatzius, Goldman Sachs’ chief U.S. economist, who has been nothing short of shrill in warning of the severe deflationary risk still facing America and the world. Furthermore, according to a National Association for Business Economics (NABE) survey, 30 percent of their members still believe deflation is our primary risk for the next five years. Although no longer the majority view, deflation is still a concern for many.

Now consider John Mauldin, who publishes one of the nation’s leading financial newsletters. Last week he cited Gary Shilling’s predictions for 2011 in his annual investment strategies article entitled “9 Buys, 9 Sells.” Shilling’s first and most emphatic recommendation is, of all things, to buy bonds! Shilling passionately lays out eight arguments, from the hard landing of the Chinese economy to the U.S. suffering a Japan-like malaise, all in favor of bonds as an outperforming asset class for the next five years.

What then is the answer? Should one buy or sell bonds? The answer lies in one’s philosophy toward investing itself. If an investor is a long-term and principled retirement investor, he or she can escape the clamor of mass hysteria by sticking to a disciplined approach that rises above such frays. Will inflation or deflation rule the day? The principled investor humbly answers, “I don’t know.” Today it looks like we are leaning toward inflation. Tomorrow, news about a country or state defaulting, China’s inflation rate running rampant, or some other disruptive event may send deflationary fears toward the ceiling. Yesterday’s news in Egypt sent investors back to bonds — go figure!

For the principled retirement investor, bonds are a critical asset class in a well-diversified portfolio. Much like a rock band that needs lead, rhythm and bass guitars backed by drums, so a retirement investor needs a bond allocation to make his portfolio sing. All the pieces of a retirement portfolio work together to make beautiful investment music. Each asset serves to help returns or mitigate risk in an atmosphere of intelligent skepticism about economic predictions. This approach dictates that it may be time to rebalance your portfolio by trimming equities that are flying high, and buying a few more bonds.