Mutual Funds

Stocks vs Bonds: A closer trade-off than you think

Maneesh Dangi | Updated on July 14, 2012

Stocks are a must if you want your capital to earn substantial real returns over a long period of time.



It has generally been thought that stocks, held long enough, are inevitably better investments than bonds.

And since the average Indian investor’s experience has been coloured by what he has seen over the last two decades, this blanket assumption has taken on somewhat sanctimonious proportions. So much so that most do not question its basic tenet: How are stocks and bonds different?

Similarities

Keen observers already know that stocks and bonds, in economic substance, are similar. Both represent claims on some productive enterprise. Stocks represent floating claims, while bonds represent fixed claims.

The ability of stock claims to float ‘up’, and compensate for rising prices (inflation) has become an important reason for their relative attractiveness.

In fact, for most parts of the last two decades, this ‘up’ factor has resulted in a significant premium paid for stocks. Corporate bonds, on the other hand, having no ready answer for the scourge of rising prices, have always sold much closer to their par value.

So how far ‘up’ did stock claims actually go? Looking back, between 1995 and 2000, the average annual return on book equity of the BSE 500 was 14 per cent. Between 2000 and 2005, it was 16 per cent. From 2005 to 2010, it was 18 per cent. And for the last two fiscal years it has dropped back to 16 per cent. So it turns out that stocks, after all, have offered a somewhat ‘fixed’ claim of around 16 per cent. And this fix, albeit loose, makes them quite comparable to bonds.

This may be disappointing news to those stock investors who think growth in earnings automatically means higher returns on equity.

But they may be failing to see that the cost of incremental capital used to generate higher earnings may keep their share of claims from continuously floating up. And, if stocks are purchased at a substantial premium then it puts even more downward pressure on their claim.

What sets them apart?

Conceptually, stocks also offer their holders an implicit ability to reinvest earnings at 16 per cent — until eternity. Bonds, in contrast, mature, and involve a periodic renegotiating of this reinvestment option.

The eternal reinvestment characteristic of stocks can be good or bad. It was good in 2003 when corporate bonds were yielding 6 per cent.

In that environment, the right to reinvest automatically at 16 per cent offered enormous value. It was a situation that left very little to be said for cash dividends and a lot to be said for earnings reinvestment.

In fact, the more money, investors thought, likely to be reinvested at 16 per cent, the more valuable they considered their reinvestment privilege, and the higher premium they were willing to pay.

If during this period, a high grade non-callable bond with a 16 per cent coupon had existed, it would have sold at far above par. And if it were a bond with a further unusual characteristic - which was that its coupons could automatically be reinvested at par, in similar bonds - the issue would have commanded an even greater premium. In essence, growth stocks retaining most of their earnings represented just such a bond.

When their reinvestment rate on capital was 16 per cent while bond rates were 6 per cent, the stock premium naturally grew. However, as bond rates eventually rose, the trade-off between stocks and bonds narrowed. And the premium shrank.

The comfort factor

While we have seen that stock claims are more or less fixed over longer periods of time, they do fluctuate somewhat from year to year. And attitudes about the future can be affected substantially by those yearly changes.

We have also seen that stocks come equipped with infinite maturities.

To compensate for these two additional risks, the natural reaction of investors is to expect a stock return that is comfortably above the bond return; today, 16 per cent on stocks versus, say, 10 per cent on bonds would seem adequate.

But when you throw in the premium paid for stocks: which in 2007 rose to as high as 500 per cent, and after much turmoil is still as high as 220 per cent; the comfort begins to subside.

Our goal at this juncture is not to recommend one asset class over the other, but to give investors a framework to think about their relative standings. It should be remembered that neither stocks nor bonds confer upon their owners a win-win proposition to be held forever.

A closer evaluation of the premium paid must be a key consideration. In fact, many stock investors of 2007 are still being schooled on this basic point.

Investor choices

Though the long-term attractiveness of equity is well established, the recent experience in stocks investing has put off a lot of investors. Many have begun to question the utility of stock investing. Don’t make that mistake.

Stocks are a must if you want your capital to earn substantial real returns over a long period of time. Just that one must choose the right time frame to assess the earned returns on stocks, i.e. at least 5 years. More importantly, stocks must be wrapped in good debt instruments.

Investors have participated in debt only through fixed deposits of banks, but there exist superior instruments of debt investing.

Fixed income funds do a better job of ensuring not only certainty but also superiority of real returns (due to better tax incidence and agile investing). It is ideal to explore some good debt funds to invest in.

(The author is Chief Investment Officer, Birla Sun Life Asset Management Company)

Published on July 14, 2012

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