Revenge of the Bond Wimps

In 1993, Professor Mankiw said bonds were for wimps because the economic research suggested that brave investors ought buy stocks.

While bonds may be for wimps, those wimps who bought bonds in 1993 had very good outcomes—perhaps better than if they had bought stocks. In the time since the "bonds are for wimps" statement, the total amount earned from buying U.S. Treasury bonds has been almost the same as from stock market trading. Furthermore, those who bought bonds knew that the U.S. federal government would pay them back. Stock owners took big risks, which included two consecutive years of serious stock market declines.

In recent decades, bonds have been the profitable tortoises to the profligate hares of the stock market. In fact, the good years to have bought bonds started in the early 1980s, more than 10 years before Professor Mankiw said bonds were for wimps. Interest rates over the last 20-plus years have seen a persistent and powerful decline (see Figure 7.1). Accordingly, bond owners have been handsomely rewarded for more than 20 years.

I remember reading a magazine article in the early 1980s that sug­gested buying what it labeled the Reagan bonds. These were long-term U.S. government bonds with interest rates significantly above 10%. I took note of the argument neither because I believed it nor because I was going to buy the Reagan bonds. I took note because the article seemed so ridiculous.

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FIGURE 7.1 20+ Years of Declining Interest Rates and Rising Bond Prices Source: Federal Reserve

Consistent with the theme of this book, bonds were a great buy at precisely the time they were hated. In the late 1970s and early 1980s, the hot investment themes were real assets, including gold, jewels, land, and impressionist paintings. In a time of inflation, everyone knew that bonds were for idiots (and probably wimpy idiots at that).

Over the last 20 years—since the time that bonds were hated—bond investors have had the best of all imaginable investment worlds. They have enjoyed high returns and low risk. Fantastic. Is this trend likely to continue?

The Mother of All Deficits: Eating Up the World's Savings?

In an episode of The Simpsons our hero Homer Simpson is sent to hell. His somewhat innovative torture is to be forced to eat donuts until it becomes excruciating. Accordingly, the devil's workers collect all the donuts in the world, which they stuff one after another into Homer's mouth. Far from being unhappy, however, Homer eats every donut in the world and still wants more.

There is a similar specter haunting the bond market; it is the voracious U.S. federal budget deficit. If, like Homer Simpson, the U.S. government eats up all the available credit, what will be left for homeowners and businesses? If there is not enough money to be borrowed at low interest rates, then large budget deficits might cause inter­est rates to rise.

There are indeed reasons to be afraid of the U.S. budget deficit as it is forcing the U.S. government to borrow an additional billion and half dollars a day. Former U.S. Senator Dirksen (who died in 1969) is reported to have said: "A billion here, a billion there, and pretty soon you're talking real money." While there is no written evidence that the senator actually made this statement, $1.5 billion a day (including weekends) is definitely real money.

The problem with large deficits is that they eat up the supply of credit or "crowd out" private investments. Here's how James Tobin, Yale professor and winner of the Nobel Prize in Economics, described the problem:

The key issue is "crowding out." Funding the Federal debt and paying interest on it absorbs private saving that otherwise could be channeled to investments that will benefit Americans in the future— homes; new plants and modern equipment; education and research; schools, sewers, roads provided by state and local governments; and income-earning properties in foreign nations.

How much will budget deficits crowd out private investments? Figure 7.2 shows budget projections as calculated by the congressional budget office (CBO). We are so accustomed to deficits that most economists chart the size of the overspending. Thus the "deficit" that is a negative number is usually shown as a positive.

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FIGURE 7.2 $500 Billion Deficits for as Far as the Eye Can See Source: Congressional Budget Office

I think the CBO assumptions are somewhat optimistic, particularly with regard to future spending. Nevertheless, the CBO picture of the future is about as accurate as is available. It estimates that the U.S. federal govern­ment deficit will be large and will not shrink for many years to come.
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Whenever you read deficit projections, you should ask, "how do these projections account for social security?" During the 2000 presidential campaign, Vice President Al Gore talked about putting the social security savings into a "lockbox." 4 This was such a theme of his campaign that he was mocked for his lockbox on Saturday Night Live. While the lockbox comedy skit was funny, the topic is deadly serious. When President Bush predicts that the deficit will be cut in half by 2008, he is using social security surpluses to cover other expenses.

Because social security currently has a surplus, combining it with other accounts makes the deficit look smaller. Since the social security funds will be spent in future years, I prefer to work with the "on-budget" figures. In other words, Figure 7.2 shows the deficit as if the social security funds were in a lockbox.

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Given that the federal government is likely to be running large deficits indefinitely, these large deficits will put upward pressure on interest rates. To understand how much, we need to put these figures into the proper perspective.