A random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing

EXERCISE 7: INVESTIGATE A
PROMENADE THROUGH BOND
COUNTRY

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Let’s face it, from World War II until the early 1980s, bonds
were a lousy place to put your money. Inflation ate away at
the real value of the bonds with a vengeance. For example,
savers who bought U.S. savings bonds for $18.75 in the early
1970s and redeemed them five years later for $25 found,
much to their dismay, that they had actually lost real
purchasing power. The trouble was that, although the $18.75
invested in such a bond five years before might have filled
one’s gas tank twice, the $25 obtained at maturity did little
more than fill it once. In fact, an investor’s real return was
negative, as inflation had eroded purchasing power faster than
interest earnings were compounding. Small wonder that many
investors view the bond as an unmentionable four-letter
word.
Bonds were a poor investment until the early 1980s
because the interest rates they carried did not offer adequate
inflation protection. But remember Part Two. Markets are
reasonably efficient, and bond prices adjusted to give
investors excellent returns over the next thirty years.
Moreover, bonds proved to be excellent diversifiers with low
or negative correlation with common stocks from 1980
through 2010. In 2010, good-quality long-term bonds were

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yielding almost 6 percent in the open market. This yield
translates freely into protection against a long-term inflation
rate of 2 percent (the actual rate during the early 2000s) and
provides a real rate of return above inflation of 4 percent. Of
course, the actual long-run rate of inflation may be
considerably greater than 2 percent. But the 4 percent real
return they promise gives a reasonably generous margin of
safety. In my view, there are four kinds of bond purchases
that you may want especially to consider: (1) zero-coupon
bonds (which allow you to lock in high yields for a
predetermined length of time); (2) no-load bond mutual funds
(which permit you to buy shares in bond portfolios); (3) tax-
exempt bonds and bond funds (for those who are fortunate
enough to be in high tax brackets); and (4) U.S. Treasury
inflation-protection securities (TIPS).