Sleep well at night: Buy bonds

Bill Gross, one of the world's best-known investors, tells Fortune that stocks may make you more money, but bonds provide peace of mind.

By Bill Gross, Fortune

(Fortune Magazine) -- I guess I'd better talk about bonds in hushed or, better yet, hurried tones - making my point and then heading for the exit before you lose whatever interest you thought you had. It doesn't bother me anymore, though, this second-class citizenship. Actually it was the first thing I realized when I signed on to the bond market in 1971, and something you should be made aware of before you read any further: Bonds don't make as much money as stocks do, so they are the wallflowers at the debutante ball - being asked to dance only out of pity, inebriation or ties to a wealthy father.

Still, they have their charms: They're less volatile, provide a higher and steadier source of current income, and allow you to sleep better at night. They make for good spouses and lasting marriages, whereas stocks - well, stocks can be sort of a fling thing. You feel good one moment, and the next you're out the door wondering what the hell happened.

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Bill Gross is the founder and chief investment officer of Pimco.

So pick your relationship wisely. Both stocks and bonds have their merits. The attractiveness of stocks right now is not hard to see. Corporate profits as a percentage of GDP are at record highs, globalization is allowing the U.S. economy to avoid a knockout blow from the popping of our self-inflicted housing bubble, and valuations (P/Es) are at reasonable levels.

Bonds, however, seem to be on some kind of magical mystery tour, with all Treasury yields, for instance, lower than what you can earn at a respectable bank. Who would go to all the trouble of calling up a broker, buying some bonds or a bond fund, and winding up with less interest than you could make at the bank?

Well, therein lies the mystery. Part of the explanation comes from the fact that current Treasury bond yields are somewhat artificially low, which is another way of hinting they might be overvalued. Their low yields (4.6 to 4.8 percent as of this writing) are partially a result of the exuberance of foreign central banks.

These financial behemoths, in possession of trillions of dollars of excess reserves (which their nations earned by selling us flat-screens and Toyotas), are using their bucks to buy more than two-thirds of all the Treasury bonds Uncle Sam issues these days. By some measurements they're buying all of them.

And because their objective is in part to support the price of the dollar and subdue the expensiveness of their own currencies (read Chinese yuan and Japanese yen), the buyers are relatively insensitive to this lower yield. By my estimate, thanks to foreign demand for bonds, yields are perhaps half a percentage point (50 basis points, as we bond geeks call it) too low.

Fifty basis points too low is another way of saying, in terms a stock guy could relate to, that the bond market might be 5 percent overpriced. But that doesn't mean you shouldn't join the party. Do you sell IBM (Charts, Fortune 500) after the company announces a $15 billion stock-buyback program? Hardly - you and the market raise the price by $5 a share to beat the company to the punch.

Same thing here. If the price of oil goes up, that puts more dollars in the hands of petro-dollar recyclers. If Americans buy more imports from China and Japan, same thing. So while the low yield of a Treasury may be telling you one thing, its potential price appreciation may be a function of an entirely different phenomenon.

Bernanke and the Fed? Sure, they're still relevant. But the power behind the intermediate and long ends of the Treasury yield curve rests with perhaps obvious but sometimes unknown foreign buyers who now hold a majority share of all Treasuries. That means that Treasury prices may go higher - and yields lower - if we buy more and more things from overseas, and those dollars come back in the form of Treasury bond purchases.

In the next issue of Fortune you'll hear from a stock guru, who will probably make you more money. But keep checking in on the bond guy, because I'll help you sleep better at night - Japan and China willing!

This is the first in a series of columns written by leading stock and bond investors. Top of page